By Todd Beaird (synchronicity)

DES PLAINES, IL (Feb. 1, 2000) -- Good risk management and strong discipline are two traits that separate successful and unsuccessful investors. We've discussed discipline before, and most of us understand that concept. Understanding and managing risk is more difficult.

What is this nebulous concept of "risk management"? Many people think of risk management the way it's traditionally defined by the Wise: "Don't put all your eggs in one basket, buy numerous mutual funds that cover different types of stocks. Do portfolio allocation so you also have a lot of bonds and CDs and money market assets. That way, if one item does poorly, you won't have big losses." To them, "risk management" means "diversification and loss avoidance."

As you know, here at TMF we think this is bad advice for most investors. If we thought like the Wise, we'd tell you to put your money in a money market fund or in CDs at your local bank and be done with it (and you'd pay for years for that nugget of "wisdom").

I've been reading the book Market Wizards recently, which is a series of interviews with highly successful traders. Most of these people follow strategies that are very unFoolish, trading short-term positions in commodities and futures markets, using highly leveraged positions. By our standards (heck, by almost anyone's standards), these guys are wild and crazy, living way out on the edge. Yet, ALL of these traders say that risk management is essential to being successful. Clearly, their definition of managing risk is different from your full-service broker's definition.

What's the difference? Risk management does not mean "avoiding risk." Risk management means embracing reasonable risk. Reasonable risk means that short-term market fluctuations, even dramatic ones, won't devastate your financial situation. In the long term (and Fools are always looking long term) you will likely wind up better off. To paraphrase Col. Kurtz from "Apocalypse Now" (or from Heart of Darkness for you literature buffs out there), "You must make a friend of risk. Risk and volatility are your friends; if not, then they are enemies to be feared."

When we tell people to get their financial house in order before investing (pay off those credit cards and start some sort of emergency fund), we're talking about risk management. When we caution investors to only put money in the market that they won't need for at least three to five years, if not longer (what I call Bucket C money), we're talking about risk management.

When Ann Coleman writes about being prepared for a financial disaster, she's writing about risk management.

When Moe Chernick cautions investors about the dangers of Euphoria, he's discussing risk management.

When we tell you to understand what you're doing before you invest, we're talking about risk management.

Here at the Workshop, we use our screens to help with risk management issues. We decide what types of stocks to hold by choosing certain screens. For example, if you're interested in "momentum" stocks of solid companies, look at the Relative Strength (RS) screens. If you want large, growing companies that you can hold for a year, check out the Spark or Keystone screens.

With all of our screens, you know the types of stocks you are holding and can see the historical range of results. You also know what you're going to do before you start (hold for a month or six months or a year, then rebalance). This is a huge help if, like me, you've been riding the Qualcomm (Nasdaq: QCOM) roller coaster this last month.

Fools don't pay attention to short-term fluctuations in the market, because we've managed risk in such a way that we don't have to. Sure, you can watch CNBC all day and check stock quotes every five minutes if you want, but wouldn't you rather be doing other things with your life? We're planning for years into the future, not just a few days ahead. The simplest Foolish investment strategy is "put money into an index fund, let it grow until retirement (and maybe even longer)."

As for those highly leveraged traders, well, they are playing a game that is so complex that it's difficult to figure out what one's level of risk is. They HAVE to check those quotes constantly, because their definition of managing risk means they have to close positions at a moment's notice if things turn against them. And sometimes even the best of them can be wrong. Just look at the near collapse of the Long-Term Capital Management fund for an example (and one of their managers was a Nobel Prize winner!).

At this point you might be wondering: "What are my risks? What is the possible downside with the Workshop strategies?" Next week we'll look at some of the worst events our screens have gone through, and make some estimates about how bad things could get. Until then, Fool on!