Chapter 16. Think Different

A Different Approach to Risk and Diversification

You can probably save a good-size forest by recycling academic papers on risk and diversification. These concepts are drummed into students' heads in academia, but their practical application is usually spoiled by long formulas awash in Greek symbols. I kept that in mind and wrote this chapter from the practitioner's point of view.

Managing Risk: What School Did Not Teach Me

One way to approach risk is from the perspective of volatility: a stock declining in price or returns falling below one's expectations. Another school of thought comes from Warren Buffett and Benjamin Graham—it looks at risk as permanent loss of capital. Are these definitions mutually exclusive? The truth lies somewhere in between.

What risk means to us is shaped by our time horizon. If you are investing for the long run—at least five years—a permanent loss of capital is the risk that you should be concerned with the most. The distinction here is that if you are armed with a long-term time horizon, volatility is a mere inconvenience (and often an opportunity, especially in a sideways market). Assuming the volatility is temporary in nature, given enough time the investment will come back to its original level.

If you have a short-term time horizon, to you volatility is not temporary. Even a temporary stock decline results in permanent loss of capital, since you don't have the time to wait it out. Permanent loss of capital is a true risk to ...

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