Why Risk Management in Investing is Critical

I often encounter people who expect my investment advice should focus on at least one of two things: identifying the investments that will earn the highest returns in the next short-term, and forecasting the returns of different investments, but especially the stock indexes. Instead, I focus on risk management. The returns will take care of themselves. You need to identify the risks you don’t want to take and remove them from your portfolio. Here’s a good example of why the other approach to investing isnt’ a good idea. It’s a profile of hedge fund manager John Paulson. He focus on looking for the next big winner and forecasting returns for assets. He had a mediocre career for a long time. Then, he hit it big with a bet against housing during the boom. Since then, he’s stumbled badly. Overall, he’s probably done well. The few investors who were with him when he bet against housing did well if they cashed in their gains. But those who kept their funds with him or who gave him money only after hearing about his winning bet against housing aren’t doing so well.

After his success in 2007, the amount of money in his funds grew to more than $30 billion. Things went swimmingly until 2011 came along. His two largest funds, Paulson Advantage and Advantage Plus, lost 36 percent and 52 percent that year, and the red streak has continued into 2012, with Advantage and Advantage Plus down 6.3 percent and 9.3 percent as of the end of May.