Is Risk Management The Same As Timing The Market?

Risk Management

I spend a lot of time discussing risk management with my patients.  There are those things we can’t control, mostly genetics and bad luck.  For everything else, there’s a plan.  Diet and exercise minimize cardiovascular risk.  Screening exams mitigate the risk of death from cancer.  Stress reduction and relationship building cut down on the incidence of depression.

In much the same way, we work towards risk management in our financial lives.  We invest in broadly indexed mutual funds that allow for the greatest diversification.  Many of us sprinkle our money between different asset classes.  We build up incomes in the W2 asset class.  Some create a side hustle and take advantage of the business asset class.  Of course, we can’t leave out real estate!

Therefore, it follows that when we see one of our asset classes overvalued (say equities), we consider managing this risk by shaving down, and deploying that revenue into an undervalued asset class (say bonds).

Right?

But wait, isn’t that trying to time the market?

I thought we FIRE enthusiasts were smart enough not to do that!

Is risk management just a fancy way of talking about timing the markets?

The Why Of Risk Management

For several reasons, I believe that risk management is prudent while timing the markets is not.  But first, a quote from Todd Tressider.

The reason risk management is essential – not optional – is because the amount you lose during the tough times determines how much you must make during the good times to meet your financial goals.

You must preserve your capital during difficult periods so that your offensive investment strategy has a larger base of capital to grow from when profitable times return.

For example, imagine a football team with such an effective defense (risk management strategy) that they never give up a first down to their opponent. This team will be very tough to beat because their offense doesn’t have to score many points to win, and they will have most of the game to do it since the defense will spend so little time on the field.

Loss Aversion vs Asset Accumulation

Most of us in the financial independence community are not looking to get rich quick.  In fact, I would compare us to the turtles of the financial world.  We are slow and steady.   Our march towards the goal of financial independence is relentless.  We earn more than most, save large percentages of income, and spend less than average.

Accordingly, it is unlikely that slightly substandard returns will derail our path to freedom.  So you may only make 6% a year and not 8%.  While this is suboptimal, it will not drastically change ones trajectory.  Catastrophic loss, however, will.

If you buy a rental property , on the other hand, end up underwater, and go into foreclosure…your financial future will be in jeopardy.

Hence, unlike timing the market, risk management allows for a reduction of total returns (if you pull the trigger too quickly) to reduce volatility and total risk.  To a risk manager, good is good enough.

Market timers, however, bow to the gods of total returns.  There are no other deities.

Value vs Arbitrage

Market timers look for inefficiencies in the market.  They have a short-term horizon, and are employed in the game of paper arbitrage.  They are trading one piece of paper for another in order to accumulate more and more.  There is no concern for the true value of that paper, only what they can get for it.  The idea is to buy low and sell high regardless of the quality of what they are trading.

Risk managers are value investors.  They think deeply about the intrinsic worth of their holdings.  They tend to carry assets for long periods, and only consider selling when they have surpassed their value.   There is no chasing short-term gains or losses.

Single vs Double Sided Risk

To time the market correctly, you have to be right twice.  Not only do you have to sell an asset when it has risen to adequate heights, you also have to buy an asset that has fallen to appropriate lows.  This is not so easy.  Calculating correctly on only one side of the equation will leave you broke.  Calculating incorrectly  on both sides will leave you in bankruptcy.

Risk managers have it a little easier.  Their main goal is to decide when an asset is overpriced and get out before they suffer major losses.  They have double the chance of navigating correctly.

In Summary

I think you can risk manage and not be chasing the market.  For instance, if you think the market is overpriced and want to steer away from equities and move capital towards bonds or real estate, have at it.  You are negotiating from a position of strength.  You’re moving long-term investments that you think have jumped their value proposition.  Once deployed in the new asset class, the capital will remain there, and not be shuffled around.

On the other hand, if you are planning on leaving your money in equities for the next twenty years, you may risk manage by leaving them in place.  The market may be overpriced now, but it will ebb and flow over the decades and eventually bring great returns.