The greatest drawback to investing is risk. There is a real possibility of sustaining a loss of capital. Unlike the prevailing academic view, risk is not equivalent to uncertain outcomes, measured by volatility. This is evidenced by the fact that upward volatility is welcomed by investors. Downward volatility, while not enjoyable in the short term, does not necessarily affect the outcome of an investment strategy. Failure of an investment strategy occurs when capital is permanently lost, usually due either to forced selling at an inopportune time or to bankruptcy of the target company. The likelihood of either of these possibilities affecting an investor can be reduced by taking precautions.
An investment strategy should be devised which does not rely on models. Models may contain unexamined assumptions or outright inaccuracies which will cause real results to vary from expectations. The capital to be invested should remain relatively small in size, which is not a problem for most investors. Partly for this reason and partly due to costs and obligations, leverage should be avoided as much as possible. Finally, investments should be evaluated for expectations of an asymmetric payoff. In my experience, stocks in general are three times as likely to advance as to decline, but income stocks in particular have an added source of growth.
When applying the investment strategy, it is best to avoid optimisation. Holding some cash allows the investor to take advantage of opportunities that arise. Holding bonds may provide a guaranteed pool of capital that can be drawn on as needed. Avoiding bureaucracy will maintain costs; involving a smaller number of people also minimises the chance of introducing errors. The principal investor should not only understand the strategy being used, but should know all the people working on her behalf and be able to evaluate whether or not the strategy is achieving her aims. Directly owning the investments helps encourage transparency and simplicity. In almost all cases, it will also avoid fraud and scams.
The strategy that I employ, personally, is as follows. I buy 100% equities because, given my earned income, I don’t require guarantees. I prefer stocks to bonds because, while both can inflict a loss of capital, stocks provide more growth potential. Within the universe of stocks, I focus on small to mid-sized companies for the same reason. I require income-paying stocks for two reasons: it imposes a certain financial rigor on companies (and allows me to determine the use of profits, not the corporate managers), but it also provides a second source of return. It seems to me that most investors focus almost exclusively on capital growth or on income yield. Stocks that provide both seem to have consistently outperformed broader market averages. I also require the companies I own to have low and preferably falling debt. This reduces the total amount of leverage I am exposed to and reduces the risk of forced actions that might cause a bankruptcy or permanent loss. I try to buy companies in a variety of economic sectors to benefit from different types of activities, but I don’t worry about model-based correlation. I keep in mind the fact that in any decision, I could be wrong. I own my stocks directly (eventually in a discount brokerage account) and try to keep up with conference calls and quarterly reports. I review the opinions of other investors, analysts and market watchers, looking for reasoning that diverges from my view.
Developing a strategy that avoids, as much as possible, the risks laid out above, allows an investor to rest assured that the most likely negative scenarios will not affect his investments. Risks cannot all be avoided with absolute certainty. Further, taking action to avoid risks comes at a cost. The resulting portfolio will be suboptimal, possibly underperforming peers or the market. The cost should not be large in good years, but the benefit will become apparent during bad years. In the case of a market crash or economic downturn, all investments will experience negative events. Optimized portfolios will fail to protect investors. Certain companies will either go bankrupt or produce results much worse than expected. By accounting for risk, an investor can moderate her expectations and should be able to avoid permanent loss.