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Principle #3: Understand the Risk Potential
Investment policy decisions should be based on the individual’s investment goals which will determine an appropriate asset mix that is consistent with the client’s needs, risk tolerance and long term capital markets outlook.
It is important that you understand the level of risk (potential capital loss) inherent in your investment portfolio. For example, if a certain asset mix fell in value by 50% at one time in the past it will probably do so again at some time in the future. In order to make an informed decision as to whether or not you want to reduce the risk in your portfolio, you need to have a full understanding of the existing downside risk.
Although an investment portfolio will eventually bounce back after it falls in value there are two problems with unexpected losses:
- It may take a long time to recover from a serious loss, bearing in mind that it takes a 100% return to recover a 50% loss.
- Emotions get involved and fear of further losses cause most investors to sell just when the portfolio is at its lowest point. Investors who sell then miss out on the gains that occur when the market eventually recovers. It is a mistake to assume that investors will remain fully invested in the markets and recover losses just because the market eventually does.
Investors should know how severe their losses could be in a serious bear market. (Please refer to the ‘Articles’ section, where you will find a list of the 7 major bear markets (40% loss on the DJIA) since 1900). If investors’ holdings are concentrated in a few securities or a hot sector, e.g. technology in the year 2000, the loss they experience could be disasterous and they might never recover from it.
Therefore, as an investor you do not want to be in an asset mix that has more risk than necessary or one which might cause you to panic at the worst time. The expected range of returns should be set out in an Investment Policy Statement.