The Biggest Fraud in the Game I don’t think there is one more important aspect to investing than understanding risk. Risk encompasses a lot of ideas about the world that come from different directions. Most financial and business books on risk take a bottom-up perspective of assessing risk. It is easy to think that low-risk investments like Treasury notes, large companies, stocks, real estate, etc. are safe places to put your money. All the money that is lost or wasted in any asset class (think subprime mortgages) is usually blamed on traders, marketers, management, and their misguided decisions. However, the most important risk is one that we create with our decisions. The single largest risk in investing is that of our own biases. The psychology and biases of decision makers are the greatest risk to an investment portfolio. The financial industry and academia generally don’t talk about this risk, but many will tell you that money managers often have the best track record because they can be highly focused on what they do every day and let someone else worry about all the other risk that is out there. However, how many people actually analyze the psychology of the money managers? How well are they managing the human aspect of investing? Do they avoid taking significant losses because they don’t want to be fired? Are they focused only on profit, which can cause them to accept risk they don’t understand? Are they blinded by data or past performances? Did they follow the herd of investment fads? Do they understand what different asset classes really are, and what their true risk is? You could also flip this question: What is the single greatest loss to an investment portfolio that you have seen? Is it the “greater fool” theory of bubbles in financial markets or is it a great loss due to manager incompetence? Is it simply bad luck? And if so, do you think most traders and money managers could not repeat this loss if they tried, or are there fundamental errors in how they are investing their money? My gut says that if you do a deep analysis of these issues, the money managers will not come out looking that great as they generally do not think about the investment part of their portfolio or think about behavioral finance. If you are like me, your analysis will find that there are few investment professionals in the world with the ability to properly manage all of the risk in an investment portfolio (or to do so effectively at all), which is why only the most skilled people can do well in the investment management business. In my career as an investment manager, I’ve looked at a lot of data, including on my own investments, and seen a lot of money managers doing it wrong (whether I was the client or not). However, I believe my greatest impact is in helping people think about the investment risk they are taking on and what kind of money manager could take on the investment portfolio as the client. Too many investors think that most money managers are doing well because they work really hard and take risks. However, they are not aware that most of the time money managers end up taking many of the same risks themselves and lose big in the process (think Pets.com). The great risk manager knows how to minimize the risk and minimize the losses. If you have ever heard someone say “I invest in the mutual funds because I don’t understand their investment process,” you have heard me explain why it is a terrible approach to investing. If you think you can invest in mutual funds or an index fund and not understand the risks and rewards, or just rely on someone else to manage the risk for you, you are making a terrible decision, as you will lose a lot of money. If you do decide to do it, be very careful and skeptical about which mutual funds and/or index funds you choose. And, in the future, if you read the financial press, newspapers, or investment magazines, keep in mind that if anyone is telling you that they are “dumb money” or other derogatory remarks about successful investing, they are usually trying to sell you something. In the future, I plan to write more about investing and the important role psychology plays in financial decision making. Please feel free to ask me any questions on anything I write or you want me to explain in more detail. Also, if you like to receive more of these types of posts, please subscribe to the blog by clicking the link below. Related posts: The Art of Value Investing by Chris Mayer Why Investors Are Getting Rich and Why You Aren't by Joel Greenblatt Tags: behavioral finance, business-model innovation, investing, risk, wealth-management, wealth-protection Follow me on Twitter at @jasonhoyt.