Ignoring Risk: The Danger of Overconfidence
Bull markets make everyone feel like a genius. But ignoring risk is how fortunes are lost.
The Overconfidence Trap
After a few wins, investors often think:
- "I've figured this out"
- "I can't lose"
- "Risk doesn't apply to me"
- "This time is different"
This is exactly when disaster strikes.
The Drunk Driver
A drunk driver who makes it home safely doesn't prove drunk driving is safe. They got lucky.
An investor who ignores risk and profits doesn't prove risk management is unnecessary. They got lucky—until they don't.
Risk management isn't about avoiding all risk. It's about surviving the inevitable bad outcomes.
Types of Risk to Consider
1. Company Risk
- Business deterioration
- Management failure
- Competitive disruption
- Fraud or scandal
2. Sector Risk
- Industry decline
- Regulatory changes
- Technological disruption
- Commodity price swings
3. Market Risk
- Recessions
- Market crashes
- Interest rate changes
- Geopolitical events
4. Personal Risk
- Needing money unexpectedly
- Job loss
- Health issues
- Life changes
Key Takeaways
- Overconfidence leads to ignoring risk
- Multiple types of risk can affect your portfolio
- Risk management is about survival, not avoidance
- Even great investors experience losses
Signs You're Ignoring Risk
Portfolio Red Flags
- One stock is 30%+ of portfolio
- All stocks in one sector
- No cash or bonds
- Using leverage (margin)
Behavioral Red Flags
- "It can't go down"
- "I'll sell before it drops"
- Not checking Health Scores
- Ignoring warning signs
Process Red Flags
- No stop-loss rules
- No position size limits
- No diversification plan
- No emergency fund
Risk Management Strategies
1. Position Sizing
- No single stock > 10% of portfolio
- Riskier stocks = smaller positions
- Leave room for error
2. Diversification
- Multiple stocks (15-30)
- Multiple sectors (4-7)
- Consider bonds/cash
3. Quality Focus
- Prioritize Health Score
- Avoid highly leveraged companies
- Prefer consistent earners
4. Margin of Safety
- Buy below fair value
- Don't pay for perfection
- Leave room for disappointment
The Kelly Criterion
Professional gamblers use the Kelly Criterion to size bets:
- Never bet everything on one outcome
- Size bets based on edge AND probability
- Survival is more important than maximum gain
The same applies to investing. Don't bet the farm on any single stock.
The Math of Loss Recovery
Losses hurt more than gains help:
| Loss | Gain Needed to Recover |
|---|---|
| 10% | 11% |
| 20% | 25% |
| 30% | 43% |
| 50% | 100% |
| 75% | 300% |
| 90% | 900% |
A 50% loss requires a 100% gain just to break even.
This is why avoiding large losses is more important than capturing large gains.
When Risk-Taking Is Appropriate
Appropriate Risk
- Calculated, understood risk
- Sized appropriately
- Part of diversified portfolio
- Long time horizon to recover
Inappropriate Risk
- Concentrated bets
- Borrowed money (margin)
- Money you need soon
- Risks you don't understand
Building a Risk-Aware Process
Before Buying
- What could go wrong?
- How much could I lose?
- Can I afford to lose this?
- Is the position sized appropriately?
While Holding
- Are fundamentals intact?
- Has risk profile changed?
- Is position size still appropriate?
- Should I trim or add?
Before Selling
- Am I selling due to risk or emotion?
- Has the risk thesis changed?
- Where will I redeploy capital?
Risk Ignorance Traps
- "It's a sure thing" (nothing is)
- "I'll know when to sell" (you won't)
- "Blue chips are safe" (they can fall 50% too)
- "I'm young, I can take risk" (you still need to survive)
Next up: Chasing performance—why yesterday's winners are often tomorrow's losers.