Probable Maximum Investment Loss and Asset Allocation

Probable Maximum Investment Loss

In our last post How Much of Your Investment Portfolio Can You Afford to Lose?” we looked at the important concept of Breakeven Loss Analysis. Here is the chart we will look at again to facilitate our discussion of Maximum Probable Investment Loss:

 

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%

 

Maximum Probable Investment Loss

 

All investors should determine what their maximum probable investment loss limit is for a one year period. Notice this is a “probable” loss not “possible” loss. Personally, I look at the chart above and am convinced that anything over 18% becomes devastating to a portfolio. You may choose a different number. But I believe studies show this approximates an ideal or optimum number for long term growth.

History shows that valuation is a key determinant of your investment returns in the long run. By looking at the past I assume the maximum probable loss is 40% in a year. You may choose a different number. This makes my target equity asset allocation 45% (18% divided by .40 = 45%). This would be the average equity target for my portfolio when good values are available.  But because I choose to minimize investment loss with a tactical asset allocation strategy; if valuations are high I might stay closer to 25% equities. But if valuations were extremely compelling, I might go as high as 65% equities.

Keep in mind 18% is the maximum I ever want to lose so I need to manage even more conservatively when values are not compelling. Therefore, I have an investment loss goal of not losing more than 10%. If I manage this way, and I reach my first limit of 10%, then I still have the ability to buy low because I haven’t lost 18%.

I’ve actually only exceeded my investment loss goal with the AAAMP once in 12 years. In 2008, with the market down 52%, (this is greater than my assumed maximum probable loss of 40%) the AAAMP was down 12%. But because I had maintained my discipline I had 88% of my capital left.  This allowed me to increase my asset allocation to equities and buy stocks at bargain prices. The market then rallied and the AAAMP ended the year down 2% (the AAAMP’s only annual loss!) compared to the market which was down 37%. I began 2009 with 98% of my capital instead of only 63% (the amount of capital left if invested in the S&P500). Yes, I only gained 20% in 2009 when the market was up 27%. But market investors lost <21%> (100 -37% +27%) over the 2 year period while the AAAMP was up 18% (100 -2% + 20%). It’s amazing what compounding will do to a portfolio, good and bad! Choose to be on the good side of compounding!

Decide what your probable maximum investment loss is and then implement an asset allocation strategy that is consistent with your decision! Now you know how; no excuses!

Related Reading: Risk Management