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If you have ever driven on California’s Pacific Coast Highway (PCH), you understand risk. For those who haven’t made the drive, you are missing out on a spectacular winding road perched between a steep cliff and the ocean well below. Staying safe on this harrowing road requires strong driving skills and a good set of brakes.

Above and beyond what is in the driver’s control, the essential defense protecting drivers is the guard rails. If the PCH were fortified with 20-foot concrete walls, the risks of driving the road would be minimal but the incredible views lost. Conversely, if there were no guardrails, the risks increase substantially. A healthy compromise lies between these two extremes.

Investors also have the ability to employ guardrails to the market. Sometimes they are large and protective. Other times they are negligible. Unfortunately, investors have little appreciation for those invisible guardrails and how to manage them. The efficacy of market guardrails should determine our risk-taking stance.

Credit

Before progressing, I would be remiss if I did not thank Steven Bregman from Horizon Kinetics. Steve brought the pitfalls of passive investing to my attention over six years ago. Here is a link to a great speech he gave at the Grants Fall 2016 conference.

Also, Chris Cole and Mike Green have done substantial work in quantifying the risks associated with the increasing popularity of passive strategies. This link offers an outstanding interview of Mike Green by Grant Williams.