Have you ever stopped to consider all of the potential risks you could run into during your day? I don't recommend it; it's not a pretty picture.
Every day, we face an almost infinite number of risks -- yet we rarely think about them.
It makes sense -- if we constantly ran through a list of all the risks we face during our day-to-day activities, many of us would never do anything.
For instance, think about letting your kids sign up for a soccer league. There are potential risks associated with driving to and from the field, unknown risks from other parents whom you know nothing about, general risks associated with being in public, risks of being exposed to someone who is sick... and we haven't even gotten to the risks associated with actually playing soccer!
Instead of being crippled by fear of risk, we buy auto, home, health and life insurance to protect ourselves from significant risks that are difficult to quantify. But when it comes to investing, few take a similar approach. Rather than thinking about specific risks and setting up safeguards accordingly, many investors are content to just sit on their hands and tell themselves, "I'm focused on the long term."
This doesn't make the risks go away, but it makes some people feel a little better after seeing their account fall by 10%, 20% or even 50%.
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Risk is one of the most important concepts to understand, yet the accepted definition of investment risk is completely incomprehensible to most investors. The standard definition of risk is reduced to the terms like standard deviations of returns, a definition I find completely useless.
When I was in the military, we used a simple definition of risk: A risk was anything that could interfere with the mission. Risks included obvious things like roadside bombs and broken-down trucks, but risks also included smaller issues, like toothaches that made a team member unable to do their job or being late for a meeting about the mission.
We understood risk affected everything and took steps to avoid as many as possible. At deployed locations, there are spare parts, food and access to medical and dental care. There are few comforts on deployments -- unless you consider an inch-thick piece of foam on a cot to be comfortable -- but there is access to everything you need to complete the mission.
This is one of the ways the military differs from investing. Some investors don't think about the mission, and they have no way of understanding risks until they know what their goals are.
My investing goals are simple: maximize wealth and be able to access my money when I need it. Probably not too different from your own financial goals.
Knowing what my goals are, even in general terms, allows me to define risk. For example, in my case, risk means not having access to my money when I need it.
This definition of risk isn't fancy or complicated, but it works for me. Every month, I need some money to be available to pay the bills. Not being able to access that money is an unacceptable risk. I also need to have money available when I retire in a few decades. Losing a significant amount along the way is an unacceptable risk.
Once I've defined risk, managing it requires a few simple steps.
Since my definition of risk is not having access to my money, I need to minimize the chance that there will be a large hit to my entire portfolio at a point when I need my money to be there. Cultivating a diverse group of options helps ensure no one investment could do significant financial harm.
By focusing on short term trades, usually open less than 90 days, I can further lower my chances of being forced to watch losses mount while a bear market unfolds. This is one of the reasons why I stagger the expiration dates on options I sell. Since I have options expiring every month, there will be time and capital available to take action during a price decline when it eventually comes.
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My other goal is to maximize wealth, so I can't afford the luxury of tying up limited capital for mediocre gains. By selling options on margin, I only have to put down 20% of the trade's potential cost to execute it. That helps me use the money I have efficiently.
Whether you're selling options or buying stocks, I believe successful investing isn't something that just "happens" to people; it requires planning just like driving a military convoy through hostile territory -- and I have applied the same level of rigor to both tasks. So far, it's served me well. I was never part of a military mission that failed, and I don't plan to be part of a failed investment mission either.
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