Predicting Investment Losses
No one wants to lose money, but risk-free investments do not yield much. Over time, leaving your money in the bank is not a profitable investment method. This means that investors must be willing to not necessarily lose capital, but to see their investments drop below cost for certain periods. But by how much, for how long and how likely is this to happen? These are fundamental questions that every investor should ask.
Much has been written about types of risk, but far less on the "quantum," namely how much your investments can decline and for how long. Generally, an investment that can lose a lot can gain just as much, but the focus of this article is on losses. (This strategy helps you to recognize your mistakes by allowing you to separate your emotions from investing, read The Importance Of A Profit/Loss Plan.)
Asset-Class Variation
Money in the bank is normally considered risk-free, disregarding inflation, but as one moves up the risk ladder through bonds, equity funds, individual equities, foreign funds, futures and so on, the amount that can be lost (or gained) increases. The process is sometimes gradual and sometimes in leaps and bounds.
It is not possible to put exact figures on what you can lose, but estimates can be made that are reliable enough to give you a good idea of what you are getting into. Also, what matters most is the relative, rather than the absolute declines or losses. That is, the fact that you can lose relatively far more with equities than with bonds is the core issue, not the actual percentages, which are extremely variable and unpredictable. (Just because you're willing to accept a risk, doesn't mean you always should, see Risk Tolerance Only Tells Half The Story.)
The Numbers
Let's take a bond fund, which is generally the next step up from cash in terms of safe investments. If times are bad for bonds, you stand to lose a few percent. Such funds tend to drop by between 3% and 12% (of course there is always the potential of higher losses). We are not talking about corporate bonds (which are roughly as risky as equities), but the usual mix that you get in a fund. Again, international bonds are much riskier and roughly equivalent to equities in terms of risk. For this reason, domestic bonds are considered a low-risk investment.
An equity fund is a big step up. When these markets take a battering, you stand to lose between 30% and 50%. Generally, the volatility is high, and charts of the ups and downs of these markets are quite radical. It is also important to note that most funds move roughly in line with the market. Unless you are with a (rare) fund that has a really serious risk-management strategy, do not expect the market to go down by 30% and your fund manager to ensure that your one only drops by 15%. This is not the way it usually works. Equity funds are thus medium-to-high risk, depending on the assets they contain.
Note also, that even if a particular fund is intrinsically medium risk, if they are all you have in your portfolio, you are definitely in a very high-risk situation. The risk you are taking with your money really must be seen in overall context of your other investments and assets. (Learn more in Modern Portfolio Theory: An Overview.)
Moving on to individual equities, you can lose a lot more. What is invested in one company that runs into bad times can plunge by 90% in a few weeks or even days. For this reason, funds are lower risk than individual equities. But a portfolio of 10 to 30 stocks with good risk management can be a whole lot more stable.
Currencies are also highly volatile, and can rise and fall by 20% or 30% within months. And if you have foreign equities, you could find that capital losses are compounded by currency losses (known as currency risk). Alternatively, the capital losses can be counterbalanced partly or largely by currency changes. However, this is a precarious game which needs to be played knowingly and with care, meaning with constant monitoring and control. (Hedging against currency risk can add a level of safety to your offshore investments read Protect Your Foreign Investments From Currency Risk.)
Futures and other highly leveraged investments are really top of the risk ladder. If things go wrong, you can lose it all overnight.
Freak Returns
The above figures are guides for normal times, that is, a normal business cycle. There are periods in which things can be a lot worse (or better). For instance, there are individual years in which an equity investment can lose you 50%. Likewise, a truly dreadful year for bonds can lose you 20%, but such periods are few and far between.
Trend Lengths
With respect to the length of ups and downs, equity and bond cycles vary, but the losses can be there for between a few weeks to a few years. There are also freak periods throughout history in which some or other asset class performs outstandingly for a couple of decades, or appallingly for equally long. There can also be trends within trends, that is, short cycles within a longer-term trend. In summary, it is very difficult to know how long the losses will be there, for this reason, work in terms of the potential losses and what you can afford, rather than the notion that you can simply "wait until they go up." Nonetheless, the shorter your investment horizon, the less risk you should take. (Learn how to reach your investment objectives while maintaining the right level of risk in Achieving Optimal Asset Allocation.)
Trend Causes
This is a complex issue and beyond the bounds of this article. So too is the question of how likely your particular investment is to take a dive. In short, all markets are subject to external forces and shocks. Political, economic, geographic, domestic, international and many other factors play a role in creating an environment that pushes the different types of investment up or down. And let's not forget psychology – if people panic and despair, an intrinsically sound investment can plummet. Conversely, if people start believing that the good times will last forever, a truly lousy investment can perform miracles - for a while. The implication of all this is to avoid low-diversification investments that can go down more than you are willing and able to accept. That way, you will not be in for nasty surprises.
Conclusions
What you can lose on a particular investment, namely its volatility, is fundamental to whether or not it is right for your circumstances and risk profile. If you are to understand what you may be getting into, you need to know in simple percentage terms what you stand to gain or lose. Only on this basis, can you build up a portfolio that is genuinely suitable. If the maximum you could lose makes your blood run cold, reduce your holding to a comfortable level or invest in something else altogether. (You might also want to check out Using Logic To Examine Risk.)
Much has been written about types of risk, but far less on the "quantum," namely how much your investments can decline and for how long. Generally, an investment that can lose a lot can gain just as much, but the focus of this article is on losses. (This strategy helps you to recognize your mistakes by allowing you to separate your emotions from investing, read The Importance Of A Profit/Loss Plan.)
Asset-Class Variation
Money in the bank is normally considered risk-free, disregarding inflation, but as one moves up the risk ladder through bonds, equity funds, individual equities, foreign funds, futures and so on, the amount that can be lost (or gained) increases. The process is sometimes gradual and sometimes in leaps and bounds.
It is not possible to put exact figures on what you can lose, but estimates can be made that are reliable enough to give you a good idea of what you are getting into. Also, what matters most is the relative, rather than the absolute declines or losses. That is, the fact that you can lose relatively far more with equities than with bonds is the core issue, not the actual percentages, which are extremely variable and unpredictable. (Just because you're willing to accept a risk, doesn't mean you always should, see Risk Tolerance Only Tells Half The Story.)
The Numbers
Let's take a bond fund, which is generally the next step up from cash in terms of safe investments. If times are bad for bonds, you stand to lose a few percent. Such funds tend to drop by between 3% and 12% (of course there is always the potential of higher losses). We are not talking about corporate bonds (which are roughly as risky as equities), but the usual mix that you get in a fund. Again, international bonds are much riskier and roughly equivalent to equities in terms of risk. For this reason, domestic bonds are considered a low-risk investment.
An equity fund is a big step up. When these markets take a battering, you stand to lose between 30% and 50%. Generally, the volatility is high, and charts of the ups and downs of these markets are quite radical. It is also important to note that most funds move roughly in line with the market. Unless you are with a (rare) fund that has a really serious risk-management strategy, do not expect the market to go down by 30% and your fund manager to ensure that your one only drops by 15%. This is not the way it usually works. Equity funds are thus medium-to-high risk, depending on the assets they contain.
Moving on to individual equities, you can lose a lot more. What is invested in one company that runs into bad times can plunge by 90% in a few weeks or even days. For this reason, funds are lower risk than individual equities. But a portfolio of 10 to 30 stocks with good risk management can be a whole lot more stable.
Currencies are also highly volatile, and can rise and fall by 20% or 30% within months. And if you have foreign equities, you could find that capital losses are compounded by currency losses (known as currency risk). Alternatively, the capital losses can be counterbalanced partly or largely by currency changes. However, this is a precarious game which needs to be played knowingly and with care, meaning with constant monitoring and control. (Hedging against currency risk can add a level of safety to your offshore investments read Protect Your Foreign Investments From Currency Risk.)
Futures and other highly leveraged investments are really top of the risk ladder. If things go wrong, you can lose it all overnight.
Freak Returns
The above figures are guides for normal times, that is, a normal business cycle. There are periods in which things can be a lot worse (or better). For instance, there are individual years in which an equity investment can lose you 50%. Likewise, a truly dreadful year for bonds can lose you 20%, but such periods are few and far between.
Trend Lengths
With respect to the length of ups and downs, equity and bond cycles vary, but the losses can be there for between a few weeks to a few years. There are also freak periods throughout history in which some or other asset class performs outstandingly for a couple of decades, or appallingly for equally long. There can also be trends within trends, that is, short cycles within a longer-term trend. In summary, it is very difficult to know how long the losses will be there, for this reason, work in terms of the potential losses and what you can afford, rather than the notion that you can simply "wait until they go up." Nonetheless, the shorter your investment horizon, the less risk you should take. (Learn how to reach your investment objectives while maintaining the right level of risk in Achieving Optimal Asset Allocation.)
Trend Causes
This is a complex issue and beyond the bounds of this article. So too is the question of how likely your particular investment is to take a dive. In short, all markets are subject to external forces and shocks. Political, economic, geographic, domestic, international and many other factors play a role in creating an environment that pushes the different types of investment up or down. And let's not forget psychology – if people panic and despair, an intrinsically sound investment can plummet. Conversely, if people start believing that the good times will last forever, a truly lousy investment can perform miracles - for a while. The implication of all this is to avoid low-diversification investments that can go down more than you are willing and able to accept. That way, you will not be in for nasty surprises.
Conclusions
What you can lose on a particular investment, namely its volatility, is fundamental to whether or not it is right for your circumstances and risk profile. If you are to understand what you may be getting into, you need to know in simple percentage terms what you stand to gain or lose. Only on this basis, can you build up a portfolio that is genuinely suitable. If the maximum you could lose makes your blood run cold, reduce your holding to a comfortable level or invest in something else altogether. (You might also want to check out Using Logic To Examine Risk.)
by
Brian Bloch
Brian Bloch has an honours degree in economics, and a master's and doctorate degrees in business administration. Brian's work has been published in the U.K. for Bloomberg Money, the Financial Times, the Guardian and Compliance Monitor. His work has also appeared on Moneyweb, a South African-based web publication. His interests lie in the area of risk and how to control it, asset allocation, and the legal aspects of investment, such as suitability and compliance. See his homepage at www.brian-bloch.com
Free Annual Reports
http://sp.fastclick.net/ad/tr/10858-64082-15546-0?mpt=dc28e6953821723a4048a26f99983739
