Portfolio management is serious business. As in every profession, there are different ways to approach the job – some better than others. Last week we reviewed one such approach with Modern Portfolio Theory (MPT). MPT showed how non-correlated asset classes can be used to mitigate risk while seeking more reward. As we noted, Modern Portfolio Theory has its limitations.
That’s one reason we wanted to highlight another approach to portfolio management: Risk Wise Investing
Regardless of your investing philosophy, there’s always a risk your investments will lose value. Recent market volatility is a good reminder of this reality. Formulated by Michael Carpenter in his 2009 book Risk Wise Investing (2009), this concept looks for a better definition of investment risk. Carpenter tries to teach investors how to manage it effectively. His website explains…
“The Risk-Wise Investor offers a totally new, user friendly, non-technical way for you to better understand and manage investment uncertainty and risk. This practical guide outlines an easy and effective, personalized risk management planning process that will allow you to plan for and deal with investment risk in bull, bear, and uncertain markets. It will also help you improve the likelihood of achieving your long-term investment goals, while minimizing the likelihood and the impact of unpleasant, negative surprises.”
Carpenter’s contribution to portfolio management is two-fold. First, he simplifies the risk side of the risk/reward investment equation. He develops several less technical (read: less mathematical) tools investors can use to manage portfolio risk. This allows average investors to try their hand at risk management without a scientific calculator. If you’re looking for a risk-management method to review, check out Chapter 11.
Second, Carpenter delves into more psychological aspects of investing by reviewing how risk affects a person. Since investors are not robots, we have to remember our human habits, characteristics, and limitations. He explores deeper aspects of behavioral finance by reviewing how the human body and brain can actually counteract sound judgment. Labeling it the Biology or Physiology of Risk, he shows how our nature affects our investment decision-making process, and how to overcome this challenge.
We can learn several things from Carpenter’s approach. For one, risk-management doesn’t always need to be mathematically modeled. In fact, over-quantifying risk can be detrimental to common sense. Simple tools sometimes give us a better perspective. Another ironic discovery is how Carpenter’s Physiology of Risk is somewhat more scientific than the financial side. He takes behavioral finance to the next level. Time will tell if the Risk Wise Investor becomes as influential as other competing portfolio theories.