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Risk Management — Some Required Reading

Risk — or more particularly, risk management — has been on the minds of a lot of investors lately.

After all, many pundits out there (including me) believe that the short-term is about to get mighty rocky.

Here are my 11 reasons the rally is doomed if you want a specific rundown of the troubles we face, but generally speaking, we are facing a slowdown in China and continued stagnation in Europe even as the United States fails to improve its labor picture.

There’s a lot of other stuff, too, like a top-line plateau for many blue chips or the threat of a war with Iran … those are the biggies.

But timing the market is a tricky thing, and when Treasuries yield so little and cash can’t keep pace with inflation, how do you mitigate your risk in the market without doing more harm than good? When are you right to follow your gut and bail out, and when are you right to stick to your guns?

I’ve been doing a lot of searching and reading on the topic and here are the most helpful tips, anecdotes and how-to columns I’ve found out there in regards to risk management:

Tail Risk: If you’re unfamiliar with the concept, “tail risk” involves the idea that the vast majority of investments will not deviate from the norm — that you’re looking at a bell curve where most action will be a little up or a little down and that a huge move  in either direction is a longshot. However, sometimes circumstances create a “fat tail” on that bell curve, where the chance of a big move down is actually much larger than a long shot. Typically this involves the overhang of some massive risk (i.e. bogus mortgages) that eventually has to correct itself. Got it? Good — because apparently a whopping 71% expect significant tail risk to shock the market in the next 12 months. The most common fears, unsurprisingly, involve mayhem in Europe. (PlanAdviser.com)

Max Pain: The concept of watching a stock go lower and lower, making you sick the entire time, is a concept that anyone who has invested long enough should be painfully familiar with. But when is the sickness a sign to bail out before further losses, and when is the sickness just your emotions getting the better of you? One of my favorite bloggers on the entire StockTwits network, Kid Dynamite, tackles this idea of “max pain” using one of the smartest pundits at CNBC as his case study. This is required reading for all traders — especially ones who are starting to feel nauseous as their holdings begin to roll back. (Kid Dynamite’s World)

The Myth of a Risk Premium: Erik Falkenstein has written a whole book about “The Missing Risk Premium” and contends that most investors don’t have to drink the Kool-Aid that claims only high risk equals high reward and that low-volatility investing is inherently low-return. He has a lot of good info about this concept of risk management on his blog, but I recently was very taken by this rather philosophical post about how we lie every day — mostly to ourselves. When the going in the market gets tough, that’s when it becomes easiest for traders to lie to themselves about their skill, their good investments and their bad ones. (Falkenblog)

Investors’ 10 Biggest Behavioral Flaws: Robert Seawright has also written a lot on the idea of fooling yourself. His post on investors’ 10 most common behavioral biases is required reading, as is his more recent series about reckoning with risk. (Above the Market)

A Broader List of Common Mistakes: I have tried to link to this as frequently as possible in recent weeks, and I will probably continue to do so for a long time because Barry Ritholtz is right on the money here with his 10 most common mistakes investors make, many of which apply to risk management (The Big Picture)

Risk On, Risk Off: So how does the broader perception of risk — and whether investors are willing to stomach that risk to go shopping for stocks — really affect the global markets? For the more cerebral and number-focused investor, here’s a 19-page working paper from the Bank of International Settlements with a lot of data and analysis of how central bank actions, changes in safe-haven assets and other elements affect global investment. (BIS.org)

At any rate, risk management seems to be what’s defining many investors these days. Hopefully some of these resources help you to get your head around what to do (broadly speaking) with your money amid the current uncertainty in the market.

Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP.

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