In an environment where almost no active investment managers can outperform U.S. stock indexes, “risk management” as a serious subject has morphed into something different. Being able to tell a risk management story well does not mean being able to invest well. Unfortunately, for managers who cannot outperform stock indexes (almost all managers!), shifting investors’ focus away from investment performance and focusing instead on telling a risk management story has become business critical — managers need something to say in investor meetings. However, sensible investors should understand that excellent investment performance naturally lends itself to excellent risk management, but telling an excellent risk management story means almost nothing as to an investor’s ability to invest.

Despite the abovementioned, let me still share a few thoughts of mine on the topic of risk management. I will attempt to ground my own “risk management storytelling” in logic and facts, rather than some sort of “fluffy” and “here and there” type of tales.

I have increasingly come to believe that in investing, risk management is not about making fewer mistakes, but about making fewer large mistakes. Losing a tiny amount of money numerous times is categorically different from losing 20% of someone’s entire portfolio a few times. The former makes little difference to a portfolio and can even be understood as an integral part of an investor’s career experience. The latter can ruin a portfolio and jeopardize an investor’s long-term record.

In a sense, the key reason why almost no managers can outperform U.S. stock indexes is that investors make mistakes — large mistakes. Pick any investor you have in mind — either a retail investor or an institutional investor. Identify the five biggest investment mistakes that the investor ever made and remove these mistakes as if they didn’t happen. Then, re-calculate that investor’s investment track record. It will be a satisfactory, if not superb, track record. That is what I mean by the consequence of making large mistakes.

Why do investment mistakes do enormous damage to a portfolio? Investment mistakes, I think, harm investors in two ways: 1) a losing time period means additional time is needed to recover from the drawdown; 2) a losing bet means the same capital could have been invested differently and might have produced better results. Investment mistakes cause investors to lose on time and lose on returns. If a mistake is extremely minuscule in its scale, its consequence will be almost unidentifiable. But large mistakes are different — they can torpedo and sink a portfolio.

Compounding affects not only investment gains but also investment mistakes. Losing bets are registered in the performance data series just like winning bets. Both compound indefinitely into the future. Plus, losing on time and losing on returns, investment mistakes compound particularly fast. Again, another reason why it is not okay to make large mistakes.

Reflecting on today, in the U.S. stock market, the biggest investment mistake so far in 2023 has clearly been “underinvestment” — many investors failed to own enough stocks to start the year with. Astute investors know by heart that historically, most stock market gains take place during the initial stage of a market recovery. By the time most investors realize the tide has turned, it is already too late, and damage is done. And I think that is what is currently happening to many active investors — while they are charging their clients a humongous amount of fees, they are underperforming stock indexes by an equally homogenous amount! Large mistakes! Not okay!

That is probably why, as I am re-reading some of the works done by David Swensen and Charley Ellis, they say and I quote, “the real secret to Yale’s remarkable continuing success is defense, defense, defense.”

Defense, defense, defense. It is a similar spirit. Mistakes are okay. Large mistakes are not okay.

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