The biggest risk of investing is permanent loss of principal. This may seem intuitive, yet few investors understand this or employ a comprehensive investment risk management plan. What is Investment Risk? Many investors believe risk is volatility expressed as beta in Modern Portfolio Theory. Some investors panic and sell after a stock takes a significant drop and often buy after a stock has risen. These investors should fear volatility. But that is risk that comes from investor behavior, not from the volatility itself. The value investor anticipates and even welcomes volatility. Real investment risk is the permanent loss of your investment capital. Not losing investment capital should be the focus of investors. My favorite approach to quantifying permanent investment loss is through the concept of maximum portfolio drawdown. Maximum drawdown is a measurement of the amount a portfolio declines from a peak to its lowest point over a period of time. This measurement of risk is the amount of portfolio principal (capital) lost from a high to a low. There is no greater risk than losing your capital. Once you lose your principal you have no capital to earn your money back. Therefore having an understanding of how compounding and volatility work together will illustrate why this concept is so important. If your portfolio falls 50% and then increases 50% you are not even, but have lost 25% of your portfolio. If you have $100 and lose $50, now you only have $50 in principal left; so the 50% increase occurs on the $50 left not the $100 you originally had. If You Lose: Gain Required to Break Even: 5% 5 10% 11% 15% 18% 20% 25% 25% 33% 30% 43% 35% 54% 40% 67% 45% 82% 50% 100% 75% 300% 90% 900% By the way, the same result occurs if the sequence is reversed. If you make 50% and then lose 50% you have still lost 25% of your portfolio. These facts make it crucial for every investor to have a maximum drawdown policy to manage investment risk. Fortunately, there are actions you can take to avoid these disastrous results and avoid the the biggest investment risk: permanently losing your capital. But you have to be willing to think differently about risk than what you commonly hear from Wall Street and the media. I want to help you change the way you manage your portfolio. You can actually increase your portfolio returns by being more conservative! Let’s look at investment risk and develop a 3 step risk management plan. 1. Asset Allocation & Market Risk (Systematic Risk) The stock market moves up and down. The stock prices of companies can be grossly overvalued, greatly undervalued, or anywhere in between at any given time. One of my favorite quotes is: “Prices fluctuate more than values — so therein lies opportunity” Joel Greenblatt Benjamin Graham demonstrated this phenomenon with the great parable, Mr. Market. You definitely should read this insightful perspective on investment pricing. Asset Allocation planning is the first step in managing investment risk. Most investors invest too aggressively (greed) when valuations are high and too conservatively (fear) when bargains...
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