Investment Iron Law V: Mitigating Investment Risk#
Investment and financial management should never prioritize returns while neglecting risks.
Analyzing Risk, Minimizing Damage#
In 1987, while working at Merrill Lynch in the United States, I met a seasoned investment veteran with decades of Wall Street experience. He once said, “I can teach you how to pick stocks in an hour, but it would take me more than five years to teach you how to manage investment risk.”
Risk is Unavoidable
In the ever-changing and unpredictable world of investment, uncertainties abound. We call these uncertainties risks. How you face these risks when they materialize is a question every investor must confront. Risk is called risk precisely because future outcomes are uncertain and unavoidable. Therefore, investment and financial management should never solely focus on returns while ignoring risks. In fact, managing risk is even more crucial. The purpose of risk management is not to eliminate risk entirely, but to acknowledge its inherent existence and impossibility of complete eradication. It’s about analyzing risk and subsequently mitigating it.
While engaging in risk management, investors must understand that “you can never be fully prepared for every risk.” You can strive to reduce risk, but don’t attempt to eliminate it completely. Many try to avoid risk through predictions or expert advice. However, no matter how accurate your forecasting techniques or how insightful the expert predictions, risk can never be fully avoided. The greatest danger of predictions is not their frequent inaccuracy, but the tendency for investors to blindly trust them, losing their risk awareness. They focus solely on whether the prediction comes true, neglecting the potential magnitude of the underlying risks. Relying solely on predictions without thorough risk analysis is extremely dangerous. Any sound investment decision inherently involves unknowns, uncertainties, and risks. Furthermore, investments without uncertainties and a degree of risk are unlikely to be good investments.
All High-Return Investments Carry High Risks
The key to successful investment and financial management lies in learning to grasp high returns while effectively managing the accompanying risks.
The investment environment is constantly changing and unpredictable. The only constant is change. Some external factors (such as interest rates, exchange rates, economic conditions, and inflation rates) are bound to change, although the nature of these changes remains unknown. Additionally, unforeseen events (such as wars, political events, and natural disasters) are uncontrollable variables. To succeed in this volatile investment world, the most important thing is not to lament change but to accept it as inevitable. Prepare for various changes and even anticipate them, because only through change can wealth be redistributed. Change is both a threat and an opportunity, depending on how you respond. Skilled investors often find profitable opportunities amidst change.
People often assume investors love risk. This is not true. Successful investors possess a unique ability to manage risk. They don’t see “risk-taking” as a source of amusement, nor do they find the act of taking risks thrilling or exciting. They take risks solely for the potential of high investment returns. Since all high-return investments inherently carry high risks, risk-taking is an unavoidable part of the journey to financial success.
Many perceive stock investment as extremely risky, believing stock investors to be risk-seekers. In reality, investing in stocks is not about loving the risk associated with stocks. It’s about understanding that all high-return investments carry high risks. To build wealth, you must take the risk of investing in high-return assets and bear the associated risks. Savvy investors understand how to take calculated risks and mitigate them. In fact, if risk mitigation measures are implemented effectively, the actual risks of investment and financial management are relatively small.
Stocks and real estate offer high returns precisely because of their inherent volatility and risk. Because most people are risk-averse and avoid investing in risky assets like stocks and real estate, those who can tolerate risk are better positioned to reap higher returns.
Many shy away from stocks and real estate primarily because they fear losses, are intimidated by future uncertainties, or can’t handle price fluctuations. In fact, short-term price fluctuations are perfectly normal and highlight the high-risk nature of high-return investments. Therefore, to achieve high returns, one must possess a spirit of adventure and be able to withstand significant volatility.
1. Unpredictable risks allow risk-takers to earn a risk premium.
2. We miss opportunities because we are afraid to take risks, not because the world doesn’t offer them.
3. To achieve financial success through investment, you must take risks, because high returns always come with high risks.
I dislike taking unnecessary risks, so before every activity, I do my best to take necessary precautions to mitigate risk.
The Forbes Philosophy on Risk#
Malcolm Forbes was a legendary figure in the American business world. He amassed a fortune by founding Forbes magazine, possessed a priceless collection, and was listed among the 400 wealthiest Americans. He not only ran a high-risk magazine business but was also a renowned hot air balloonist and motorcycle enthusiast. He once rode a motorcycle across Eurasia from Paris to Beijing. He traveled the world, flying hot air balloons across the United States, and even ventured to Turkey and China, setting multiple world records and attracting widespread media attention, making him a household name.
Averting Danger Before it Happens, Ensuring Safety
Some labeled him an “adventurer.” He offered an insightful explanation of this label, saying, “Many people think I’m a risk-lover. I’m not. Like most people, I strongly dislike risk. The reason I take risks today, despite my aversion to them, is simple: all good things in life come with risks. I take risks purely to live a rich and fulfilling life.” “Riding in a hot air balloon or on a motorcycle across different lands broadens one’s horizons and exposes one to the world’s beauty, enriching life. However, many people, despite yearning for these experiences, hesitate to engage in them because they perceive them as high-risk activities. But, once you actually try them, you’ll find that if you take adequate precautions beforehand, the risks involved are quite small.” “I dislike taking unnecessary risks, so before every activity, I strive to take the necessary preventative measures to mitigate risk.”
Malcolm Forbes was risk-averse, but he took risks to experience the good things in life, and after taking those risks, he sought ways to mitigate them.
Assess the Rewards and Risks, If It’s Worth It – Take the Risk
Are you afraid of taking risks? If so, you are not alone. Most people are afraid of taking risks; very few are natural risk-takers. But why are some people so composed in the face of risk, and even achieve success through it? It’s because they understand the principles of “nothing ventured, nothing gained” and “no high risk, no high return.” Indeed, the correct perspective on risk should be: take risks worth taking, and then find ways to mitigate them.
Successful investors are driven by the pursuit of “wealth.” Although they must be prepared to withstand the pressure of price fluctuations, as long as the expected return is high and there’s a risk premium, risk-taking will ultimately lead to success.
Before every investment, it’s essential to understand the potential risks and develop contingency plans for every possible scenario. Analyze the degree of blind risk-taking, estimate the probability of success, and continuously re-evaluate throughout the process. I recommend investors create a risk-reward assessment table before making any investment, weighing all factors. Ask yourself, “Can I bear the consequences if the worst-case scenario unfolds?” and “Is the potential return of this investment attractive enough?”
Always plan for the worst and prepare for the best. This is especially true for investment and financial management. Before making any investment, no matter how confident you are, you should ask yourself, “What is the worst possible outcome?” Then ask, “Can I bear the consequences if the worst happens?” If the answer to both questions is yes, and the expected return is high enough, then you should invest. If the worst-case scenario is unbearable, then no matter how alluring the potential reward, you should categorically refuse to invest.
Don’t Take Unnecessary Risks
If you ever visit Las Vegas or Atlantic City, observe the lavishly decorated casinos carefully. You’ll notice the absence of clocks and windows, and the ever-present bright lights. “There’s no time in the mountains, and no time in casinos.” Why are there no clocks or windows in casinos? It’s because casinos leverage the law of large numbers to win your money. The lack of clocks and windows is designed to blur the lines between day and night, encouraging gamblers to play endlessly until they lose track of time. The longer you play, the more times you play, the higher the probability of the casino winning. As the number of games increases, the expected value gradually reveals itself. Gambling inevitably leads to losses because its expected value is negative. This might not be apparent in a few instances, but over time, the expected value becomes increasingly evident. Therefore, prolonged gambling inevitably leads to losses. This explains the saying “nine out of ten gamblers lose” and “long-term gambling leads to certain loss,” which aligns perfectly with the principle of the law of large numbers. The law of large numbers states that the more times a game is played, the closer the return gets to the expected value of that game.
I had a classmate in the doctoral program at UC Berkeley who excelled in mathematics and frequented Las Vegas casinos on weekends. Curious, I asked him, “You’re so smart and you know that gambling is designed against the players. Are you trying to win money?” He replied, “I never go there to win money. I gamble to relieve stress.” He explained that after a heartbreak in college, he tried various methods to cope, such as drinking, speeding, and traveling, but none were effective. He eventually found that only gambling could allow him to truly escape. Gambling can be a form of entertainment, but it’s certainly not a way to make money. Its expected average return is lower than bank deposits, making it impossible to build wealth through such activities.
Many people hold the misconception that “high risk always equates to high return.” This misunderstanding stems from a misinterpretation of the definition of “return.” High risk might indeed offer high potential returns, but this represents the maximum possible return, which has a very low probability. However, in the context of “high risk, high return,” the “return” refers to the expected return (long-term average return), not the maximum possible return. Indeed, gambling boasts incredibly high maximum potential returns, but its average, or expected, return is negative. Taking such risks is not only unprofitable but also detrimental.
There are No High-Return, Zero-Risk Investments
Success requires risk-taking, but risk-taking doesn’t guarantee success. One must take calculated risks. A calculated risk is one that, on average, offers high returns over the long term.
Some people’s problem isn’t a lack of risk-taking spirit but a tendency to take unnecessary risks. They don’t know what risks to take to achieve financial success. As detailed in previous chapters, the cornerstone of investment success is the power of compounding, which only works effectively with high returns. Over the long term, stocks and real estate are asset classes that offer high expected returns. Therefore, taking calculated risks means investing in assets with high expected returns and bravely bearing the associated risks.
Consider a game where participants must pay $100. There’s a 99.9% chance of losing $100 and a 0.1% chance of winning $95,000. Would you play? In a survey I conducted with hundreds of students, over 65% chose to play this high-risk game. Their reasoning was simple: while the risk was high, the potential loss was capped at $100, while the potential gain was a whopping $95,000. However, the expected return of this game is negative. Even if you get lucky and win once, in the long run, you’re bound to lose. This is a classic example of a risk not worth taking.
Avoid risks that don’t offer high returns. Activities like futures trading, margin trading in foreign exchange and bonds, lotteries, and short-term stock trading all carry high risks and often have negative returns. In other words, these are high-risk, negative-return activities. You can engage in these activities for entertainment, but never delude yourself into believing they will bring you wealth.
There are no high-return, zero-risk investment opportunities. In a society filled with intelligent individuals, such opportunities are impossible. If someone offers you a high-return, risk-free investment opportunity, they are undoubtedly trying to scam you.
I remind readers again: don’t blindly chase high returns and jump into risky ventures. Speculative activities like those mentioned above are not truly high-return investment tools, but they are definitely high-risk endeavors. These risks are not worth taking.
Absolute safety is a myth. The real danger is not taking any risks. In a volatile environment, the biggest risk is not taking any risks.
Don’t Shy Away from Risk Entirely#
The future world is changing rapidly. Changes will accelerate across all aspects of business, economics, finance, politics, and society, creating a more complex financial landscape. It’s foreseeable that wealth redistribution will also accelerate. Risk aversion is human nature. In the past, you could live a stable life without taking risks. However, in the face of the volatile investment environment of the future, not taking risks becomes the biggest risk of all.
Fear of Falling Will Keep You from Running Fast
Fear of risk prevents many from investing, causing them to miss out on the opportunity to build wealth. Keeping money in a bank seems safe and risk-free. However, as previously analyzed, inflation severely erodes the real value of money. From a financial management perspective, keeping money in a bank carries the greatest risk. Decades later, when those around you who invested wisely become millionaires, those who kept their money in banks may face financial hardship. My point is: don’t shy away from risk entirely. Risk isn’t as terrifying as it seems. Taking calculated risks with high potential returns is absolutely worthwhile.
I’m often asked, “Teacher, will the stock market fall again?” My answer is, “I don’t know.” Then they ask, “When will it start rising?” My answer remains, “I don’t know.” They further inquire, “Which stock should I buy? Can you give me a hot tip?” My answer is still, “I don’t know.” Then they question skeptically, “How can you invest when you don’t know anything? Isn’t that too risky?” My response is, “You must invest and manage your finances without knowing the answers to these questions to succeed.”
Why invest when the answers are unknown and the future is uncertain? The reason is simple: While the future is full of risks, one thing is certain: as long as the economy continues to grow and corporate profitability rises, the long-term return on investment in the stock market will inevitably surpass bank deposits, and by a significant margin. Repeatedly avoiding worthwhile risks will prevent you from building wealth.
How to Cultivate a Risk-Taking Spirit
A courageous risk-taker is not someone without fear, but someone with the power to overcome it.
The spirit of adventure isn’t innate; it’s developed through practice, through taking risks, failing, taking risks again, failing again… step by step.
Everyone is capable of taking risks, and everyone has had the experience of taking bold risks. As toddlers, we dared to stand and learn to walk, falling and getting back up countless times. Learning to ride a bicycle involved numerous falls, followed by getting back up, falling again, and getting back up again, until we finally mastered it. Most life skills, such as swimming, skating, driving, public speaking, and so on, are not innate instincts. Learning these skills requires going through a phase of risk-taking, embracing the spirit of perseverance, and trying repeatedly. Learning investment and financial management is no exception; it requires this standard process of risk-taking. To become a successful investor, you must first discard the habit of risk aversion, rediscover your lost instinct for adventure, and cultivate a healthy risk-taking spirit.
Does investing have to be extremely risky? In reality, the risks involved in investment and financial management are no greater than the examples mentioned above. It’s just that as we reach an age where we believe we are qualified to manage finances, our risk-taking spirit has diminished significantly. As children, almost everyone learns to walk. A little older, most learn to ride a bicycle. But as we grow older, the number of people who learn more adventurous activities like swimming and skating decreases considerably. In adulthood, the number of people comfortable with public speaking dwindles even further.
Our risk-taking spirit seems to fade with age. This is partly because experiencing failures and mistakes naturally leads to frustration and discouragement. Without sufficient motivation, we tend to avoid taking risks to minimize the blow of failure. Another contributing factor is traditional education. Out of a desire to protect children, adults often reprimand them for any risky behavior, instilling a habit of prioritizing safety and avoiding mistakes. Children then strive to be “good kids” who never do anything wrong. As we age, this risk aversion becomes ingrained. While avoiding risk isn’t inherently bad, excessive risk aversion becomes a significant obstacle to successful investment and financial management.
The First Priority of Financial Management: Overcoming Fear
When individuals can control their fear, they can control their thoughts and actions. Self-control enables them to remain calm in chaotic environments, make necessary decisions without being paralyzed by the uncertainty of the outcomes, and be prepared to bear the consequences of failure when things don’t go as planned. This courage and risk-taking spirit in the face of danger are essential qualities for investors.
Courageous risk-takers are not fearless; they simply recognize risk and overcome their fear of it. Courage stems from controlling fear, and cultivating a risk-taking spirit begins with understanding risk.
To become a successful investor, you must first discard the habit of avoiding risk. Admittedly, changing long-held risk-averse habits is no easy feat. However, since risk-taking is an indispensable element of successful financial management, the first priority in learning to manage your finances is to overcome fear and force yourself to take risks. Cultivate a healthy risk-taking spirit, invest bravely in assets with high expected returns, and bear the associated risks.
Top performers in any field achieve success by bravely facing their fears and taking calculated risks. Those who achieve financial success and fulfill their dreams through investment share this same spirit of adventure. Remember: excessive caution hinders success. Without a spirit of adventure, dreams will forever remain dreams.
Mastering risk is the foundation of successful financial management.
Overcoming Risk – Start Small#
Skilled risk-takers never test the depth of the water by stepping in with both feet. They extend one foot first, and if the situation seems unfavorable, they quickly withdraw. An African proverb states, “Only a fool tests the depth of the water with both feet.” Similarly, only a fool would go all-in without any investment experience.
Gain Experience with Small Amounts of Money
When faced with unfamiliar investment opportunities, don’t put all your eggs in one basket. Start small. Skilled generals don’t expose their main forces to unnecessary danger. To gather intelligence and gain an advantage, they deploy small reconnaissance units deep into enemy territory to identify low-risk, high-impact attack strategies.
The same principle applies to investment risk-taking strategies. When dealing with unfamiliar investments, unclear situations, or a lack of confidence, avoid going all-in. Start small, using small amounts of money to gain experience and familiarize yourself with the situation. Once you have sufficient experience and confidence, then you can invest larger sums.
As the saying goes, “All things are difficult before they are easy.” The best way to overcome fear is to confront what you fear head-on. Since risk-taking is an essential part of building wealth through investment, don’t shy away from it. Start with small investments to build your risk tolerance. With experience, the feeling of fear will gradually dissipate. By progressively overcoming small fears, you can then face larger risks. You’ll soon discover that the experience gained through risk-taking is helping you steadily approach your dreams.
Once You’re Used to Risk, You’ll Find It’s Not So Scary
Risk aversion is human nature, but don’t let a single investment failure shatter your confidence and prevent you from investing again, turning you into a perpetual loser. Conversely, don’t let a stroke of good luck make you forget the existence of risk, leading you to borrow heavily and invest recklessly, resulting in irreparable losses. Successful and unsuccessful investors alike fear risk; they simply react to it differently.
Dear readers, if you haven’t tried investing yet, take the plunge for the sake of building wealth! If you take appropriate risk mitigation measures after investing, I can assure you from experience: “The risks of investing are actually quite small, even smaller than the risk of riding a bicycle. After 10 or 20 years of investing, when you see your wealth growing rapidly, the feeling will be hundreds of times better than riding a bicycle.”
The first element of investing is a strong adventurous spirit, seeking to generate substantial risk premiums between risk and safety. No matter what investment you choose, as long as it offers high expected returns, risk is inevitable. Investors should embrace calculated risks and accumulate financial knowledge and experience along the way. Risk naturally decreases with accumulated knowledge, and wealth grows at an increasing pace.
This book dedicates significant space to discussing risk because the biggest challenge people face in financial management is their inability to confront risk directly. They don’t know how to face or manage risk, and some are even afraid to take any risks. They don’t realize that the biggest obstacle to successful investment and financial management is the fear of risk. This mindset is understandable, as most investment and financial management decisions are made amidst uncertainty and change. In short, to achieve financial success through investment, you must be willing to take calculated risks. Currently, many people suffer significant losses due to blind risk-taking and involvement in high-risk speculative activities.
If you are unwilling to take risks and prefer a conservative approach, be prepared for a life of mediocrity, as this is unavoidable. Of course, there’s nothing wrong with a conservative and mediocre life if it brings you happiness. The choice is yours. People usually regret the things they didn’t do, not the things they tried. Therefore, my advice is: Take risks, but be cautious and learn how to manage them.