The biggest risk of investing is losing your principal. This may seem intuitive, yet few investors have a risk management plan for their portfolio.
Volatility if often referred to as risk and expressed in standard deviation or the variance of a stock price. But the real risk of investing is portfolio losses and can be expressed as maximum portfolio drawdown.
Maximum Portfolio Drawdown
Maximum portfolio drawdown is a measurement of the amount a portfolio declines from a peak to its lowest point over a period of time. This important measurement of risk is the amount of portfolio principal lost from a high to a low.
There is no greater risk of investing than losing your principal. Once you lose your principal you no longer have the capital to make 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. Follow me here, if you have $100 and lose 50%, now you only have $50 in principle left; so the 50% increase occurs on the $50 not the $100 you originally had.
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.
Multi-decade bear markets typically produce large percentage swings in stock market indices both up and down. This is exactly what we have experienced since 2000. Large swings produce the kind of results we looked at above with a buy and hold mentality.
Fortunately, there are ways to avoid these disastrous results and minimize portfolio drawdowns. But you have to be willing to think differently than what you commonly hear from wall street and the media.
I want to help you change the way you manage your portfolio. By being more conservative you can actually increase your portfolio returns. Here is further related reading to start developing your new risk adverse portfolio management plan: