Risk and uncertainty

Financial decisions are made without knowing the future. Good risk analysis therefore focuses on ranges of outcomes, probabilities, exposure and what would happen if an assumption is wrong.

Risk versus reward

A possible gain should be considered alongside the amount that could be lost and the probability of each outcome. A large potential return does not automatically make a decision attractive if the downside is poorly controlled.

Position sizing

Position size determines how much of a portfolio is exposed to one idea. Smaller positions reduce the damage caused by individual mistakes and make it easier to survive inevitable periods of poor performance.

Diversification

Holding different exposures can reduce dependence on one company, sector or economic outcome. Diversification is most useful when the underlying risks are genuinely different rather than merely represented by different tickers.

Behavioural risk

People can become overconfident after success, anchor to purchase prices, chase recent winners or avoid admitting that evidence has changed. A repeatable decision process helps reduce these biases.

Risk management is not about eliminating uncertainty. It is about making sure uncertainty cannot do disproportionate damage.