“To my mind, the three most important principles when it comes to investing are Albert Camus’ principles of ethics: God is dead, life is absurd and there are no rules.” Hugh Hendry

Risk must be taken for rewards, or returns, to be reaped. This is as true in investments as it is in any other of our pursuits. Too much risk, meanwhile, may lead to points of no return, and this is to be avoided. Fine.

Risk limits are relatively well understood and deployed, especially when they are grounded in common sense rules of thumb and avoid the pitfalls of reliance on mathematical models that offer spurious precision and emotional comfort.

But it is within the outer bounds of no risk and too much risk that lies the subtle and nuanced art of risk taking. It is customary in the industry for this art to be commoditised, by classifying assets into risk levels (in proportion with their historical volatility) and deploying them in combinations that seek to match a specific risk profile. But an investor prepared to think for herself can generate a dynamic (as opposed to static) risk stance that will both better match her individual profile and increase her chances of generating greater returns over time.

How is this to be achieved?

I propose that, for every investor at a given point in time, there is a point of indifference along the risk spectrum. Managing risk implies identifying, and balancing on, this indifference point.

Let me illustrate.

If you have 100% of your assets invested in small cap equities, you are hoping for a continued rally in risk assets.

Conversely, if you have 0% of you funds invested, and have all your money in cash, you have everything to benefit from a market crash and nothing from an asset appreciation. You are hoping for a sell off.

(Hope, it should be noted, should have nothing to do with risk management. It reveals a vulnerability, or an imbalance in the starting position).

Somewhere along the risk scale, between the hope for asset appreciation and the hope of a sell off, must lie a point where you are indifferent between both. You have sufficient skin in the game to benefit from the upside, and enough dry powder to deploy in a downturn, by buying cheaper assets opportunistically if they lose value. By balancing on this point of indifference, investors are best positioned to manage their risk calmly and avoid typical behavioural pitfalls.

This approach is malleable, allowing for the point of indifference to vary between different individuals in accordance with their circumstances, objectives and tolerance for adversity. It is also flexible through time, enabling investors to dynamically adjust the risk they take in relation to their understanding of the market ecology (the point in the cycle, or level of valuations) as opposed to being trapped within a pre-determined and static risk profile.

We are often told that diversification is the key to risk management, and it certainly is a major part of it. Managed well, it reduces the volatility of returns without hampering the long term prospects. But in an environment where most assets are expensive relative to their own history, it is important for investors to think about their overall risk stance alongside the quality of the portfolio diversification.