Do You Understand the Core Lessons From These Case Studies?

Before moving to the next chapter on building a personal risk framework, test your understanding of the case studies and lessons covered in this chapter. This quiz is not a test you pass or fail; it is a diagnostic tool. If you answer most questions correctly, the concepts have stuck. If you find yourself uncertain, revisit the earlier articles in this chapter. The topics tested here are foundational to risk management.

Quick definition: A case study quiz reinforces learning by asking you to apply concepts to scenarios and to explain principles in your own words.

Key takeaways

• These questions focus on application, not memorization. Can you identify risks in scenarios?
• Some questions have clear right answers. Others require judgment and depend on your specific situation.
• Discussing your answers with other investors can deepen understanding.
• Use this quiz periodically to refresh your memory and test yourself after market moves.

Questions

1. Concentration Risk Recognition

You have a portfolio of <$100,000. Your three largest positions are each <$15,000 (15% of your portfolio). The next seven positions range from <$6,000 to <$8,000 (6-8% each). You also hold <$10,000 in cash (10%).

a) What is your largest position concentration?

b) Do you consider this portfolio well-diversified? Why or why not?

c) What is one risk you might be overlooking?

Answer Guidance:

• a) 15% (the three positions of <$15,000 each)
• b) No. Even though you have ten positions, the top three account for 45% of the portfolio. A decline in any single sector or correlated group could have outsized impact.
• c) Hidden correlation (the positions might be correlated during stress); sector concentration (you may not realize all three large positions are in the same industry); leverage amplifying one bad position.

2. Due Diligence Failure

You are considering a hedge fund with reported 12% annual returns, 6% volatility over the past five years, and representation from several well-known institutional investors. A friend recommends the fund highly. The fund manager is willing to accept your investment immediately.

a) What due diligence questions should you ask before investing?

b) What is a major red flag in the above scenario?

c) What documentation should you require before committing capital?

Answer Guidance:

• a) How is the strategy actually executed? Can you see a sample calculation? How has the strategy performed in specific adverse years (2008, 2011, 2015, 2018, 2020)? What is the fund's largest position? What leverage does the fund use? What is the fund's liquidity policy (redemption periods)?
• b) The willingness to accept your investment immediately. Funds with good due diligence processes typically have a waiting list or require a multi-month evaluation period. Fast onboarding can suggest the fund is raising capital quickly, a potential red flag.
• c) Audited financial statements from an independent auditor; prime brokerage statements; a breakdown of performance by strategy and time period; references from other institutional investors; compliance certifications.

3. Stress Testing and Leverage

You have a position in a convertible bond (a bond with an embedded equity option). You have <$50,000 in the position and <$100,000 in total portfolio capital. You are using <$50,000 in margin to establish the position, effectively a 2:1 leverage ratio on the convertible.

The position has a large upside if the underlying stock rises significantly, and downside protection from the bond element. You believe the position is hedged.

a) What is your actual leverage ratio on the full portfolio?

b) What happens to your <$100,000 equity if the position loses 20%?

c) Is the convertible bond truly hedged? Why or why not?

Answer Guidance:

• a) 1.5:1 (you have <$100,000 in equity and <$150,000 in positions, financed with <$50,000 in margin)
• b) You lose <$10,000 (20% of <$50,000 position loss), but because you used margin, the impact on your <$100,000 equity is <$10,000 divided by your effective leverage. Actually, it's more direct: you lose 10% of your equity. But if margin is called and you cannot meet it, losses can accelerate.
• c) No, it is not truly hedged. The bond element provides downside protection against the equity declining, but the position as a whole is leveraged and exposed to credit risk (the issuer of the bond could default) and volatility risk (implied volatility in the option component could change, affecting the bond's value). The hedge is partial and relies on assumptions that can break.

4. Counterparty Risk

You are depositing <$600,000 in a brokerage account at a regional broker known for good service and low commissions. The broker is SIPC-insured.

a) What is your SIPC protection level?

b) What protections apply to the <$100,000 above the SIPC limit?

c) What additional due diligence should you conduct on this broker?

Answer Guidance:

• a) <$500,000. SIPC insurance covers each customer account up to <$500,000. The remaining <$100,000 is not covered by SIPC.
• b) Additional protections depend on the broker's arrangements: Does the broker have excess insurance? Does it segregate customer assets in a special custodian account? These should be documented in the broker's disclosures or available on request.
• c) Check the broker's regulatory filings (via SEC Edgar or FINRA BrokerCheck); confirm that customer assets are truly segregated; verify the broker's capital ratios; ask about the broker's prime brokerage relationships (who is the clearing broker?); confirm that cash in the account is held in a bank account (not in the broker's general account).

5. Decision-Making and Bias

You purchased a stock at <$50. It has declined to <$35 over the past six months. The stock is no longer trading below your calculated fair value. But you are down 30%, and you believe the stock will eventually recover.

You also have an opportunity to invest <$10,000 in a different stock that meets your criteria and is trading below your calculated fair value.

a) Should you deploy capital in the new opportunity, hold the <$35 stock, or sell the <$35 stock and buy the new stock?

b) What cognitive bias might be influencing your thinking about the <$35 stock?

c) What is the correct framework for this decision?

Answer Guidance:

• a) Ideally, sell the <$35 stock and buy the new stock, provided the new stock has better risk-return characteristics. The decision should be based on prospective returns and risk, not past losses.
• b) Loss aversion (the desire to avoid crystallizing a loss) and sunk cost fallacy (continuing to hold because of past losses). The amount you paid for the stock is irrelevant; only the prospective return matters.
• c) For each investment, ask: At the current price, does this represent a good risk-reward opportunity? Compare the <$35 stock to other alternatives at its current price, not to your entry price. If the new opportunity offers better risk-adjusted returns, deploy capital there.

6. Portfolio Rebalancing

Your target allocation is 70% equities and 30% bonds. Your actual allocation has drifted to 78% equities and 22% bonds. Equities have appreciated significantly. You are concerned that rebalancing now would lock in gains and reduce upside.

a) Should you rebalance? Why?

b) What is the purpose of rebalancing?

c) How often should you rebalance?

Answer Guidance:

• a) Yes. Rebalancing is not about locking in gains; it is about maintaining your intended risk profile. If equities were supposed to be 70% but are now 78%, you are taking more risk than intended. Rebalancing by selling some equities and buying bonds brings you back to target.
• b) Rebalancing maintains your intended risk level, ensures you are not drifting into unintended concentration, and mechanically implements a "buy losers, sell winners" discipline, which is historically advantageous.
• c) Quarterly or annually, with rebalancing triggered when allocations drift more than 5% from target. Some investors use threshold-based rebalancing (when any allocation is >5% away from target) rather than time-based rebalancing.

7. Illiquidity and Position Sizing

You have an opportunity to invest <$50,000 in a private company equity stake. The stake is illiquid; you could potentially sell, but it would take several months and might result in a significant discount. You have <$200,000 in total capital.

a) What percentage of your portfolio is the <$50,000 investment?

b) Would you make this investment at the same size as a publicly traded stock investment? Why or why not?

c) How would you adjust your position size for illiquidity?

Answer Guidance:

• a) 25% of your portfolio
• b) No. Illiquid investments should be sized smaller than liquid ones because you cannot exit quickly. A 10% allocation to a liquid stock is manageable; a 10% allocation to an illiquid private stake is riskier.
• c) Reduce the position. A common approach is to limit illiquid positions to 5-10% of portfolio value, significantly smaller than liquid positions. This ensures you can meet liquidity needs without being forced to sell the illiquid position at a discount.

8. Assumption Breakdown

You have constructed a hedged position: long <$5,000,000 in longer-dated Treasury bonds and short <$5,000,000 in shorter-dated Treasury bonds. The strategy is a "curve flattening" bet, assuming that the yield curve will flatten. You used this strategy successfully in 2012-2014.

In 2022, the Federal Reserve begins aggressively raising rates. The entire yield curve shifts higher (rates rise across all maturities).

a) Is your hedge working as intended?

b) What assumption has broken?

c) How could you have identified this risk in advance?

Answer Guidance:

• a) No. When the entire curve shifts higher, both the long and short positions lose value at similar rates. The hedge does not protect you; both positions move together.
• b) The assumption that the yield curve would flatten. Instead, the entire curve shifted higher. This is a parallel shift, not a curve-flattening move.
• c) Stress-test the strategy under scenarios other than curve flattening: parallel shifts in the curve (rates up 1% across maturities, rates down 1% across maturities), steepening moves (long rates up more than short rates), and volatility changes (even if spreads are stable, volatility changes affect relative value). If the strategy fails under plausible stress scenarios, reduce the position or reconsider it.

9. Real-World Application

You are evaluating whether to increase your position in a technology stock that has doubled over the past year. The stock is now <$100, up from <$50. Your position is currently 8% of your portfolio.

The stock remains below your calculated fair value. You are tempted to increase the position to 12-15% of your portfolio.

a) What questions should you ask before increasing the position?

b) What rule from this chapter would guide your decision?

c) If you increase the position, what adjustment might you make elsewhere in the portfolio?

Answer Guidance:

• a) Has anything changed in your thesis or the company's fundamentals? Is the increase in fair value estimate justified by improved business performance, or has the market simply gotten more bullish? What would make you wrong? How does the position sizing compare to your other positions? Does a 12-15% position violate your position-size limits?
• b) Rule 1: Limit single-position size to no more than 5-10% of portfolio capital. At 8%, you are at the upper bound. Increasing to 12-15% would violate this rule.
• c) If the stock continues to appreciate and you want to maintain conviction, you could rebalance by trimming the technology position back to 8-10% and deploying proceeds to underweighted areas (bonds, cash, other sectors). This maintains discipline and diversification.

10. Integration and Synthesis

Draw on all the lessons in this chapter to answer the following:

You are starting a trading account with <$100,000. You have several investment ideas and want to build a disciplined portfolio. You have not experienced a major loss, so your risk tolerance is theoretical.

a) What is your first step before deploying capital?

b) What rules and limits would you establish?

c) How would you monitor and review the portfolio?

d) What is the biggest risk in a newly established <$100,000 portfolio?

Answer Guidance:

• a) Establish your investment policy: target allocation, position-size limits, leverage limits, cash reserves, acceptable asset classes, due diligence requirements. Write these down. This takes a few hours but prevents years of poor decisions.
• b) Position-size limits: no position >10% of capital (<$10,000), no position contributing >1% of portfolio volatility. Leverage limits: no leverage, or minimal leverage (<1.1:1) with explicit approval. Cash reserve: maintain 10-15% in cash. Risk limits: portfolio volatility should not exceed 12% annually (implied by 70% equity / 30% bond allocation or similar).
• c) Monthly monitoring of position sizes and portfolio allocation. Quarterly comprehensive review: concentration metrics, largest positions, sector exposure, liquidity, cash reserves, thesis validation. Rebalance when allocations drift >5% from target.
• d) Overconfidence in your ideas and lack of experience with losing positions. The biggest risk is not that the market will move against you (that is inevitable), but that you will break your rules when you are excited about an idea or when you are losing money. Discipline matters more than brilliance.

Decision flow

Here is a decision tree for evaluating whether to add a new position to your portfolio:

Analysis Tips

When reviewing your answers:

• For questions 1-7, focus on whether you correctly identified the risk or principle, even if your exact wording differed from the guidance.
• For questions 8-9, assess whether your reasoning was sound and whether you applied the concepts from this chapter.
• For question 10, compare your rules to the examples throughout the chapter. Your specific numbers may differ, but the structure should be similar.
• If you answered fewer than 7 of 10 questions correctly, revisit the earlier articles in this chapter, especially the articles on concentration risk, due diligence, and practical lessons.

Common Mistakes in This Quiz

Confusing position size with diversification. Having a position that is 5% of portfolio capital might still be too concentrated if it is in a single stock in a volatile sector. Diversification requires correlation analysis, not just position counting.

Underestimating counterparty risk. SIPC insurance is valuable, but it is not total protection. Understanding your broker's capital, custody arrangements, and regulatory status matters.

Overweighting the role of past performance. A fund with strong historical returns is not a guarantee of future returns, especially if the strategy relies on assumptions that could break.

Failing to stress-test assumptions. The strategies that seem most hedged are often most vulnerable to assumption breakdown, because the hedge relies on assumptions continuing to hold.

Treating rules as flexible. Rules work because you follow them even when you do not want to. If you break rules frequently, you do not have rules; you have suggestions.

Related concepts

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• ./19-due-diligence-lessons.md
• ./01-ltcm-full-story.md

Summary

This quiz reinforces the core lessons from the case studies in this chapter: concentration risk is real and often hidden, due diligence is foundational, leverage amplifies risk, assumptions can break, and discipline matters more than brilliance. If you answered most questions correctly, you have internalized the lessons. If you struggled, the concepts are worth revisiting. The stakes are high: poor risk management can wipe out a portfolio in a single adverse move. Good risk management, implemented consistently, is the difference between investors who survive and prosper and those who do not. Use this quiz as a tool to test yourself, share your answers with other investors to deepen your understanding, and revisit it periodically to refresh your memory.

Next

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