You can control investment losses by determining your probable maximum loss and choosing an asset allocation that is consistent with your philosophy. How much of your investment portfolio can you afford to lose is one of the most critical questions you should ask yourself.
I believe 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 their products.
Portfolio Volatility and Managing Risk
Risk management analysis is an important part of any investing plan. Volatility 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 return to concentrate on high risk stocks. 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 you need to break even grows exponentially.
If You Lose:
Gain Required to Break Even: