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.)
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.)
by Brian Bloch,
Fight Back Against Inflation
During an economic downturn it seems investors and consumers are always fixated on the state of our economy and as a result, the focus is on next day, next week and next month. Considering that unemployment during these periods can rise as high as 10%, it's very easy to understand the short-term perspective with which many concern themselves. After all, it's hard to tell someone to think about the next year or two when they are concerned about the security of their employment. Indeed, if you are without a stable source of employment, not much else matters in terms of the state of the economy.
As hard as it is to believe during an economic downturn, economies recover, and in all likelihood come out even stronger than before. History is a very powerful indicator. Over the last 100 years, the United States
Inflation Defined
However, along with economic healing comes a necessary consequence: inflation. We are often taught in basic economics that inflation means "too much money chasing too few goods." Actually, a more accurate definition of inflation is simply too much money. Somewhere in this world there will always be goods or services for that money to find a home. (For more on inflation, read the Inflation Tutorial.)
Too much money can be a necessary consequence of financial recovery. The Fed's stimulative efforts during the financial crisis of 2008-2009 are an example of that. Moreover, as that recession became global, more and more countries expanded their balance sheets to aid their economies. In 2009, we saw the central bank really play its role as the "lender of last resort."
The Hidden Tax
Why is inflation so important not only to investors, but to average working Joes and their families? If you thought government taxation was the biggest threat to your hard-earned income, you are being victimized by the ravages of inflation.
Simple math reveals that inflation is a far more onerous tax than anything to come out of Congress. During years with 4% inflation, anyone with an interest-bearing account yielding 4% is effectively paying a 100% tax on interest income. In other words it makes no difference if you put your money in a savings account earning zero percent during periods of zero inflation or a savings account that pays you 4% a year during years when inflation is 4%. Either way, the effect is a "tax" that leaves the individual with no real income. Whatever money is spent comes out of capital.
In fact, most people would find it outrageous to pay an income tax of 120%, yet folks don't realize that 6% annual inflation is the economic equivalent.
The Light at the End of the Tunnel
Fortunately, there's light at the end of the tunnel in terms of what individuals can do to minimize the consequences of inflation, and in many cases, benefit from it. Once you understand the causes and consequences, the next step to combat the ravages of inflation is to learn to protect yourself from it.
Inflation doesn't occur over night. But you will see signs. When a recession hits, inflation will almost certainly follow, but not always immediately. Consumers tend not to spend and financial institutions and other businesses must work on deleveraging their balance sheets. But inflation is not something that needs to be timed in order for people to minimize its impact on the purchasing power of money.
What's important is that people realize the hidden taxation that inflation brings and how to arm yourself for its to erode your savings. (To learn more, see The Importance Of Inflation And GDP.)
Young Adult
For young individuals just getting into to the workforce or soon to be joining it, the ultimate tool against inflation is very simple: continue to invest in yourself. With decades of earning power in your future, the most significant way to benefit from the general effects of inflation is to continually improve in your particular craft.
A school teacher for example can invest by pursuing additional degrees which leads to pay raises and increased job security. Whatever it is you do always continue to invest in yourself. Doing so will give you the most bang for your buck.
Also, and this is important, spend less than you earn and avoid credit cards as much as possible. The secret to financial independence is to simply spend less than you earn, period. It's hard for me to sympathize with folks who are losing million dollar homes and seven-figure salaries and finding themselves broke. Sure the economy can be a catalyst, but the real issue is that many people live above what they can truly afford. A job loss is painful, but when you know you have no debt obligations, it's easier to pick yourself up and move on to something else. (For more, read Invest In Yourself With A College Education.)
Working Professional
Regardless of the state of the real estate market, owning a home is still the best investment you can make if it's done for the right reasons. Those reasons are that you desire to own the home as a place to live and not a property to flip. And now more than ever, buying a home is an excellent idea.
The most obvious example was the residential real estate market in 2008 and 2009. It was a buyer's dream. You could have negotiated down a price of a home to over 50% less than what they sold for only three years earlier. But aside from getting a good price, taking on long-term mortgage debt today will benefit the borrower at the expense of the lender. Inflation decreases the purchasing power of money, so if you take a 30-year mortgage today, you will likely be paying back that mortgage with less valuable dollars. On top of that, buying at depreciated levels vastly increases the likelihood that your home will appreciate in value over time.
And yes, every month you make a mortgage payment - assuming it's a principal and interest payment - is like putting money into a savings account. When home prices are depressed and inflation is a worry, it can be a great time to buy a home. And if it's your first home, you have money to make a suitable down payment (10-20%) and your credit is good, banks are happy to lend to you. (To learn more, check out Top Tips For First-Time Home Buyers.)
Retirees
For those about to retiree, it's not as simple because unfortunately, time is not on your side. If you have been doing the things outlined above - you have little or no debt and own a home (which by should be close to mortgage free), then the best options are investments like Treasury inflation protected securities. Exposure to 'AAA'-rated corporate bonds may also be wise for part of your portfolio. Also, it's a good idea to have a little exposure to stocks, particular large cap value names. These companies tend to do relatively well in most economies and offer respectable yields.
Knowledge is Power
Understand that the hidden effects of inflation are the key to protecting yourself. Inflation affects us all in some fashion. You don't need to know that inflation is happening this month or next to prepare yourself. You just need to understand that attention to simple financial prudence - avoidance of debt, living below your means and making sensible investments - will likely leave you better protected in the future. (For a complete look at the causes and implications of inflation, see our Inflation Tutorial.)
Inflation Defined
However, along with economic healing comes a necessary consequence: inflation. We are often taught in basic economics that inflation means "too much money chasing too few goods." Actually, a more accurate definition of inflation is simply too much money. Somewhere in this world there will always be goods or services for that money to find a home. (For more on inflation, read the Inflation Tutorial.)
Too much money can be a necessary consequence of financial recovery. The Fed's stimulative efforts during the financial crisis of 2008-2009 are an example of that. Moreover, as that recession became global, more and more countries expanded their balance sheets to aid their economies. In 2009, we saw the central bank really play its role as the "lender of last resort."
The Hidden Tax
Why is inflation so important not only to investors, but to average working Joes and their families? If you thought government taxation was the biggest threat to your hard-earned income, you are being victimized by the ravages of inflation.
Simple math reveals that inflation is a far more onerous tax than anything to come out of Congress. During years with 4% inflation, anyone with an interest-bearing account yielding 4% is effectively paying a 100% tax on interest income. In other words it makes no difference if you put your money in a savings account earning zero percent during periods of zero inflation or a savings account that pays you 4% a year during years when inflation is 4%. Either way, the effect is a "tax" that leaves the individual with no real income. Whatever money is spent comes out of capital.
In fact, most people would find it outrageous to pay an income tax of 120%, yet folks don't realize that 6% annual inflation is the economic equivalent.
The Light at the End of the Tunnel
Fortunately, there's light at the end of the tunnel in terms of what individuals can do to minimize the consequences of inflation, and in many cases, benefit from it. Once you understand the causes and consequences, the next step to combat the ravages of inflation is to learn to protect yourself from it.
Inflation doesn't occur over night. But you will see signs. When a recession hits, inflation will almost certainly follow, but not always immediately. Consumers tend not to spend and financial institutions and other businesses must work on deleveraging their balance sheets. But inflation is not something that needs to be timed in order for people to minimize its impact on the purchasing power of money.
What's important is that people realize the hidden taxation that inflation brings and how to arm yourself for its to erode your savings. (To learn more, see The Importance Of Inflation And GDP.)
Young Adult
For young individuals just getting into to the workforce or soon to be joining it, the ultimate tool against inflation is very simple: continue to invest in yourself. With decades of earning power in your future, the most significant way to benefit from the general effects of inflation is to continually improve in your particular craft.
A school teacher for example can invest by pursuing additional degrees which leads to pay raises and increased job security. Whatever it is you do always continue to invest in yourself. Doing so will give you the most bang for your buck.
Also, and this is important, spend less than you earn and avoid credit cards as much as possible. The secret to financial independence is to simply spend less than you earn, period. It's hard for me to sympathize with folks who are losing million dollar homes and seven-figure salaries and finding themselves broke. Sure the economy can be a catalyst, but the real issue is that many people live above what they can truly afford. A job loss is painful, but when you know you have no debt obligations, it's easier to pick yourself up and move on to something else. (For more, read Invest In Yourself With A College Education.)
Working Professional
Regardless of the state of the real estate market, owning a home is still the best investment you can make if it's done for the right reasons. Those reasons are that you desire to own the home as a place to live and not a property to flip. And now more than ever, buying a home is an excellent idea.
The most obvious example was the residential real estate market in 2008 and 2009. It was a buyer's dream. You could have negotiated down a price of a home to over 50% less than what they sold for only three years earlier. But aside from getting a good price, taking on long-term mortgage debt today will benefit the borrower at the expense of the lender. Inflation decreases the purchasing power of money, so if you take a 30-year mortgage today, you will likely be paying back that mortgage with less valuable dollars. On top of that, buying at depreciated levels vastly increases the likelihood that your home will appreciate in value over time.
And yes, every month you make a mortgage payment - assuming it's a principal and interest payment - is like putting money into a savings account. When home prices are depressed and inflation is a worry, it can be a great time to buy a home. And if it's your first home, you have money to make a suitable down payment (10-20%) and your credit is good, banks are happy to lend to you. (To learn more, check out Top Tips For First-Time Home Buyers.)
Retirees
For those about to retiree, it's not as simple because unfortunately, time is not on your side. If you have been doing the things outlined above - you have little or no debt and own a home (which by should be close to mortgage free), then the best options are investments like Treasury inflation protected securities. Exposure to 'AAA'-rated corporate bonds may also be wise for part of your portfolio. Also, it's a good idea to have a little exposure to stocks, particular large cap value names. These companies tend to do relatively well in most economies and offer respectable yields.
Knowledge is Power
Understand that the hidden effects of inflation are the key to protecting yourself. Inflation affects us all in some fashion. You don't need to know that inflation is happening this month or next to prepare yourself. You just need to understand that attention to simple financial prudence - avoidance of debt, living below your means and making sensible investments - will likely leave you better protected in the future. (For a complete look at the causes and implications of inflation, see our Inflation Tutorial.)
by Sham Gad,
Forex Autopilot – A Wise Investment?
It’s a well known fact that trading in the forex market can be an excellent way to make money. Anxious to participate, I was inspired to start searching for a way to learn all about this market and how to trade it. But after long hours of crawling thru websites too numerous to mention, reading [...]
Posted August 30th, 2008 under Forex Trading, Forex Trading Software. Tags: Charles Floyd, fores, Forex Auto Pilot, forex autopilot, forex market, Forex Trading, Marcus Leary, trading plans, trading strategy, trading techniques. Comments: 8
Posted August 30th, 2008 under Forex Trading, Forex Trading Software. Tags: Charles Floyd, fores, Forex Auto Pilot, forex autopilot, forex market, Forex Trading, Marcus Leary, trading plans, trading strategy, trading techniques. Comments: 8
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