Risk Management : Art of Living another day !!!


Today’s post is by Manish Dhawan, founder of Mystic Wealth and my co-host at Stoic Investing Podcast.

I know of very less people, who are as conscious and stringent on Risk management, as Manish is. He follows a very different style than mine. He is a proponent of Trend Following against my Value Investing focus (even though he is a die hard buffett fan who has read more on Buffet than many Value investors I have met in India and even at the Mecca at Omaha). The following article serves as good reminder on risk management along with a precursor to our Podcast with Ralph Vince

Over to Manish !!!

The Investopedia definition of Risk management is,

Risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management occurs any time an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given his investment objectives and risk tolerance”


That didn’t help did it. Let us break it down.

Risk management is perhaps the most important topic you would cover in your journey towards financial acumen. Irrespective of what sub sect you have chosen, be it value investing, technical analyses, momentum investing, growth investing or trend following, you need robust Risk management to sustain yourself in this financial jungle.



So… What is Risk management ?

Cutting to the chase, in very simple terms, I define Risk Management as a plan to ensure that I live to see another day. That is it. That is all there is to it. If the worse that can happen, does not kill you, rest of it would be only the upside.

A perfect question at this time would be, If risk management is that simple, how come people blow up?

The entire calculation is based on what is the worst that can happen, people blow up when they calculate this figure incorrectly or over estimate their uncle point.

What is an Uncle Point?

A point at which your losses mount to such a level that you psychologically give up and walk out. Your uncle point can be a lot different from what you presume it to be. It all depends on how well you know yourself. I know a lot of people who claimed would be OK to see their portfolio go down 60-70% as they are LONG term investors, but ended up selling their entire portfolio in February 2016, which was just a 20-30% fall. It is a lot easier to shoot a tiger in a video game, in reality when a Tiger shows up, you wet your pants on his roar only, leave alone his attack.

So let us say you have been able to accurately narrow down your uncle point, now what.

Now, you draw a hypothesis, what is the worse that can happen. You see through history, what has transpired so far, important thing to remember is NOT to discard 2008 crash as one-off outlier event, in fact you should err on the other side and add a MOS (Margin of safety) and think in terms of every new black swan is always bigger and bolder than its predecessor.


If you have applied any lever on your portfolio, the calculation takes a whole new dimension. If you have not done it already, please go through our introductory blog on OPTIONS and why we never SELL NAKED.

Another important point on the topic of leverage is this.

How many of you have heard of the name, Rick Guerin, common you guys.. you proudly claim to be Value investors and you have never heard of him? Watch this video below


So Warren says, if you are slightly above average, as long as you don’t blow up, you are bound to grow Rich, such is the nature of the markets, such is the upward bias. Just don’t BLOW UP.

There is no reason for an intelligent person to use leverage as he will get rich anyways, and if you are not intelligent god forbid, leverage is the last thing you need.

So how do you ensure that you do not BLOW UP !!

Warren Buffet claims Risk is in NOT KNOWING what you are doing. No amount of diversification would help if you are shooting in the air. And on the other hand, if you know what you are doing, diversification is just plain stupidity.

And so Warren Buffet’s Risk management comes from the edge he generates by digging deep into the stock he buys. His Risk management comes from Margin of safety over and above the intrinsic value of the stock.

His inverted maths goes like this, what is the probability that my hypothesis is correct. What is the upside if it is correct, what are the odds that it is not correct and what is the downside if that is the case.

Let us say he comes up with a stock idea. He assigns a probability of 70% to it. He thinks if he is correct, stock should be 3x and if wrong it should go to zero.

If we use Kelly Formula based on the above figures, it suggests to bet 60% of corpus in the bet. That is too aggressive by any imagination. It makes no practical sense as 02 bad bets in a row would render you bankrupt.

I know some very aggressive speculators who bet half of what Kelly suggests after putting in a very conservative probability.

But remember what Ed Seykota has to say on the subject,

There are Old Traders and there are Bold traders, but NO OLD BOLD TRADERS

What Kelly does NOT factor in is the risk of ruin. No matter how thorough your research is, there can be factors outside of your control, unfathomable, unforeseen which can result in back to back bad bets.

To factor those in, a typical buy and hold investor puts in 2% of its corpus in a given stock. Giving him theoretically a 50 stock portfolio.



So far we have talked about the risk on per stock basis, what about Total risk at a portfolio level. If we have 50 stocks with a stop loss at 0 (No stop loss for value investors) and we have put 2% of PF in each, we have a portfolio heat of 100%. (very rare that it would manifest but for the sake of calculations let us continue)

You need to keep this statistic in mind too whether you are willing to put your entire net-worth in equity or do proper asset allocation.

Key Points and Conclusion

Risk management needs to incorporate your entire net-worth, first level of management comes at macro level where you do asset allocation between real estate, debt and equity.

Second level risk management comes from calculating your Portfolio heat. What is the maximum amount you are willing to lose at a portfolio level. In our above example if the heat you can take is 50%, you can buy only 25 stocks risking 2% of your PF in each while putting the rest in liquid funds.


Third level risk management comes from calculating your risk at individual stock level. How much you bet on a given stock?Surely as you can see, this is a very conservative way of looking at stock market. But remember, that is how you start. Like we discussed earlier, you got to protect your downside, the upside takes care of itself. Just do not go broke. Market will provide enough opportunity for you to make a lot of money. Remember, when a Bull run comes along, it pulls everyone, A monkey throwing dart at random stock portfolio returned 70% in 2014 (it is not a figure of speech, it is an actual back-test)  and supposed who’s who genius lost 70% of their net-worth in 2008 crash.


And ofcourse, avoid leverage at all cost. As you grow in confidence and expertise, you can increase your bet size. Value investors increase it by their conviction and trend followers increase it by defining specific exit points (not waiting for a zero on stock)

Hope this article helped. Once again keep in mind the whole game is to stay long enough for a juicy full toss to come along. Just don’t get out, it is a test match.

P.S Stay tuned as we interview Ralph Vince for our podcast series who has done some pioneer work in the field of position sizing and money management.