How Much of Your Investment Portfolio Can You Afford to Lose?

Investment Loss Analysis

How much of your investment portfolio can you afford to lose, is one of the most critical questions you should ask yourself when working on your risk management plan. I think most investors have been taught to invest too aggressively.  We will examine why you shouldn’t listen to the industry and media which is dominated by institutions that want you to buy and sell products.

Risk Management Analysis

Risk management analysis is an important part of any investing plan. Volatility (risk) doesn’t seem to bother most investors during bull markets. This is one of the reasons investors are “lulled” into taking on additional risk as markets rise. Studies show that investments with lower volatility tend to produce lower returns. This causes investors seeking higher rates of returns to concentrate on higher risk stocks. Riskier stocks tend to be smaller and fundamentally weaker than the average stock. These more speculative stocks tend to lead the market up during rallies, but collapse in down markets.

 

The following chart exhibits the challenge of making your investment back after you lose it. Notice that the more you lose, the amount needed to breakeven grows exponentially. This is because the money lost is capital that is no longer available for investment. If you lose only 10%, you still have 90% of your capital available for investment. If you lose 50% you only have 50% of your capital available for investment, so a 100% gain is required to get back to breakeven.

 

Breakeven Loss Analysis Chart

                             Gain Required

     If you lose:        to Breakeven____

          5%                     5%

         10%                   11%

         15%                   18%

         20%                   25%

         25%                   33%

         30%                   43%

         35%                   54%

         40%                   67%

         45%                   82%

         50%                 100%

         75%                 300%

         90%                 900%

 

Why Is It SO Important to Avoid Investment Losses?

 

 When you experience large losses you have less to invest and then your portfolio is in a position that will probably take years to get back to breakeven. The reality of break-even loss analysis makes losing 50% of your money intolerable! Even if the market gained 10% per year, and you were 100% invested, it would take 7 years (7 instead of 10 because of compounding) to get back to breakeven. This is unacceptable. You need to invest in a way that allows you to buy low and sell high, not the opposite.

 

Investment Losses and Risk Management

 

 

All investors need to have a plan for controlling their investment losses. Many in the financial industry will tell you to place stops on your individual stocks. But is it possible they recommend this because it creates more trading and therefore more commissions? Why should you sell a stock when it goes down? If the company’s prospects haven’t changed maybe you should buy more not sell at a loss. What if you used a tactical asset allocation to minimize investment loss and buy more stocks when they are bargains?

Instead of putting stop losses on individual investments, develop an asset allocation for your portfolio that controls your investment losses. Most investors invest too aggressively; they have been taught an outdated buy and hold strategy that forces them to sell in bear markets because they get to the point where they can’t stand the pain of a bear market anymore, and they sell at the wrong time.

The next AAAMP Blog post we will discuss the concepts of Maximum Probable Investment Loss and Asset Allocation. You will learn how to think differently by determining your risk parameters and allocate your portfolio in to minimize risk and maximize rewards.