In an article for the New York Times, financial historian and consultant Peter Bernstein argues that there is a fundamental need for a broader understanding of risk management within the investment world. Any risk management system must confront a simple question: "What happens if we're wrong?" This seems simple enough - but plenty of investment banks and hedge funds never dealt with the question during the formation of the housing bubble:

"Risk management, then, should be a process of dealing with the consequences of being wrong. Sometimes, these consequences are minimal — encountering rain after leaving home without an umbrella, for example. But betting the ranch on the assumption that home prices can only go up should tell you the consequences would be much more than minimal if home prices started to fall. In this assumption, the word “only” is ridiculous. There are no “onlys” in the future. More things can happen than will happen.

Under those conditions, risk management should concentrate either on limiting the size of the bet or on finding ways to hedge the bet so you are not wiped out if you take the wrong side — if home prices do start to go down, or even stop rising. Risk management is fundamentally different from managing volatility, which is how many investors view it. Volatility is often a symptom of risk but is not a risk in and of itself. Volatility obscures the future but does not necessarily determine the future.

Effective risk management starts with the recognition that any forecast can be wrong, then weighs the consequences of being wrong. Only then can we decide whether to make a bet, whether to hedge that bet and how to execute the hedge if needed."

One of the all-time investment classics, of course, is Peter Bernstein's Against the Gods: The Remarkable Story of Risk. Bernstein literally wrote the book on risk management. For members of the TradeKing Community: What steps are you taking to manage risk in your portfolio?

[image: Against the Gods]