How much could you lose?

How to Determine Your Downside Risk

Working with an investment professional is a worthwhile endeavor; especially if you lack the experience or time to properly manage your investment portfolio. Taking advantage of an expert’s guidance to build your nest egg can help usher in gains that will set you up comfortably during your next phase of life.

That’s a good thing.

However, investors should never depend exclusively on an advisor to manage their portfolio. Having a clear understanding of your portfolio’s composition will help you make better decisions that are in your best interest. For instance, investors should be familiar with their portfolio’s downside risk – the estimate of the worst-case scenario for an investment or how much that investment stands to lose.

The downside risk is a fundamental metric used to determine the extent to which an investment’s value could decline. This measure is extremely important for investors nearing retirement – those who have less time to recover from any declines in the market. These changes can impact an investor’s projected lifestyle in retirement or determine whether or not retirement must be postponed one or more years into the future.

If you’ve tried googling “downside risk” before, the search results returned might as well have been written in another language. Before scheduling an appointment with your advisor, here are a few simple steps to review your investments and determine the level of downside risk in your portfolio.

  1. Begin by deciding how much downside risk currently exists in the market. Depending on the upcoming outlook, this can be anywhere between 20% to 60%. For this example, we’ll use a midrange downside risk value of 40%.
  2. Determine the equity allocation of your portfolio. Identify the percentage of your investments which are comprised of stocks, stock mutual funds, international mutual funds, or REITs. Also, include high yield bond funds in this percentage allocation. (Basically everything except U.S. Treasury bonds and cash.)
  3. Take your downside risk projection from #1 and multiply that by the percentage of your portfolio comprised of equity allocations in #2.

For example, let’s say 70% of your portfolio is invested in equity and high yield positions. If you anticipate a 40% decline in the market, your portfolio has a 28% downside risk. Conversely, if 100% of your portfolio is invested in fixed and equity position, you are exposed to the entire potential 40% decline in the market.

Sounds simple, right?

There are definitely more nuanced calculations that a professional advisor will and should consider when determining your downside risk. However, armed with this reasonable estimation, you can work with a financial planner to determine if your portfolio is properly balanced and positioned to weather any downturns in the market.

The market is currently experiencing at an all-time high.  Do you know what your downside risk is? If you would like assistance in determining your investment portfolio’s exposure to a decline in the market, schedule an appointment with a Precedent Asset Management financial advisor today.