A Simple Concept

May 23rd, 2008 at 09:09am Tracy Beard

  Tracy S. Beard, CFP® 

One of the most powerful illustrations I have shared with my clients over the years involves a very simple math concept.  Imagine you started with a portfolio worth $100,000. If you lose 50%, how much return do you need to earn to get back to your original principal?  Often an investor will respond by answering 50%. However, a 50% return on $50,000 would only bring the portfolio value to $75,000.  The correct answer is 100%.  Yes, that is correct.  A 50% decline requires a 100% return to merely recover.  This is why controlling risk in a portfolio is so important. When investors ignore the benefits of diversification and become speculative, they are subjecting themselves to this type of speculative risk.  So what should an investor do?  Listed below are a few methods that may help protect your portfolio from speculative risk. 

• Avoid bad timing decisions and don’t let your emotions dictate your investment decisions – Too often investors misjudge risk.  They think risk is high when risk is really low.  For example, when the market corrects by 10%, most investors do not want to put money in the market.  However, they usually line up to make deposits when the market is on an extended run up.  What are implications of bad market timing?  If you bought into the market in March of 2000 (when it felt good), your portfolio of Large US stocks fell over 50% by 2002.  If you pulled your money out at the end of 2002 (when risk was actually low), you would have missed double digit stock returns for each of the next four years.
• Broadly diversify across a number of assets classes throughout the entire planet – While diversification seems boring, it works. You will not hit a home run in any given year since you will not have your entire portfolio in the hottest market.  Fortunately, you will not strike out either. 
• Stop watching the financial networks every day – When one watches the news everyday, they tend to believe markets are more volatile than they actually are.  This can play with your emotions and cause poor market timing decisions. 

For more on building a diversified portfolio, feel free to visit our website at www.savantcapital.com

Entry Filed under: Financial Planning, Investments