Dividend Value Builder Newsletter

Investment Risk Management Plan

by | Risk

Risk Management in Bull and Bear Markets

The biggest risk of investing is permanent loss of principal. This may seem intuitive, yet few investors understand this or employ a comprehensive investment risk management plan.

What is Investment Risk?

Many investors believe risk is volatility expressed as beta in Modern Portfolio Theory. Some investors panic and sell after a stock takes a significant drop and often buy after a stock has risen. These investors should fear volatility. But that is risk that comes from investor behavior, not from the volatility itself.

The value investor anticipates and even welcomes volatility. Real investment risk is the permanent loss of your investment capital. Not losing investment capital should be the focus of your risk management plan.

My favorite approach to quantifying permanent investment loss is through the concept of maximum portfolio drawdown. Maximum drawdown is a measurement of the amount a portfolio declines from a peak to its lowest point over a period of time. This measurement of risk is the amount of portfolio principal (capital) lost from a high to a low.

There is no greater risk than losing your capital. Once you lose your principal you have no capital to earn 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. If you have $100 and lose $50, now you only have $50 in principal left; so the 50% increase occurs on the $50 left not the $100 you originally had.

If You Lose:

Gain Required to Break Even:

























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 to manage investment risk.

Fortunately, there are actions you can take to avoid these disastrous results and avoid the the biggest investment risk: permanently losing your capital. But you have to be willing to think differently about risk than what you commonly hear from Wall Street and the media.

I want to help you change the way you manage your portfolio. You can actually increase your portfolio returns by being more conservative!  Let’s look at investment risk and develop a 3 step risk management plan.

Related Reading:  5 Portfolio Risk Management Strategies

1. Asset Allocation & Market Risk (Systematic Risk)

The stock market moves up and down. The stock prices of companies can be grossly overvalued, greatly undervalued, or anywhere in between at any given time. One of my favorite quotes is:


“Prices fluctuate more than values — so therein lies opportunity” Joel Greenblatt


Benjamin Graham demonstrated this phenomenon with the great parable, Mr. Market. You definitely should read this insightful perspective on investment pricing.

Asset Allocation planning is the first step in managing investment risk. Most investors invest too aggressively (greed) when valuations are high and too conservatively (fear) when bargains are available.

Figuring your personal probable maximum loss is an exercise that will make you think hard about how much risk to accept. This is the amount of capital you could lose in a significant bear market. Of course this depends on your chosen asset allocation. This exercise will cause you to adjust your asset allocation to better reflect your willingness (or should I say unwillingness) to lose your capital.

Part of asset allocation planning is being ready to take advantage of opportunities. If you are going to have cash to take advantage of the market when it offers bargains you can’t be heavily invested when valuations are high.

If you buy when prices are below their fundamental value you have room for errors, misjudgments, or unforeseen problems. When you buy at prices that are fully or over valued you are more likely to suffer large losses when something goes wrong.

2. Diversification and Specific Investment Risk (Unsystematic Risk)

Individual investments can increase or decrease in price without any correlation to the market. This is specific risk to the individual investment or small group of investments. Specific risk is risk that is distinct for that investment.

The good news is that specific risk is easily mitigated in a portfolio through diversification and valuation investing. Investment diversification is frequently described as the only “free lunch” in investing because, done properly, it has the ability to lower risk without lowering expected returns.

Diversification Rules

Proper diversification puts a distinction between investing and gambling. If you are taking risk that could have been mitigated by diversification, then you are taking unnecessary risks for which you are not being compensated. This is gambling not investing.

If you only have one investment your portfolio risk would be extremely high. Your portfolio returns might be high or low, but would depend on one investment. However, if you own 15- 30 investments you “smooth out” your returns. The variance of your portfolio returns will be reduced.

Diversification rules are a part of position sizing and will set boundaries and provide the framework for a risk management plan. Diversification reduces risk by combining investments that lower asset correlation.

Diversification Rule #1

5% Rule – Never Put More Than 5% in Any One Stock

Company specific risk can be nearly eliminated with diversification. You defeat the purpose of diversification if you put too much capital in one stock. In my opinion, you should never put more that 5% of a portfolio in one stock.

The 5% rule is especially critical when the company is the investor’s employer. Holding a large percentage of an employer’s company stock exposes the investor to losing their job and their retirement portfolio if the company experiences fraud or difficulties (i.e. Enron).

Diversification Rule #2

15% Rule – Never Put More Than 15% in Any One Mutual Fund or ETF

Fund management risk is a form of specific risk that comes from owning mutual funds or Exchange Traded Funds (ETFs). Even the best managers or indices (many ETFs follow specific indices) fall on hard times and surprise investors with poor performance.

Diversification Rule # 3

25% Rule – Never Put More Than 25% in Any One Sector

Sector or industry risk is the risk of an entire sector doing poorly. The perfect example of this was the 1999-2000 period when technology stock became the favorite of institutions and individuals. Many individual investors and mutual funds invested too much of their assets in technology stocks.

When prices collapsed in 2000 many investors lost their capital permanently due to lack of diversification. Limiting the percentage invested in one sector or industry can spare a portfolio from devastating losses due to hard times or overvaluation in one sector.

Diversification rules set boundaries and provide a framework within your risk management plan. Setting limits on allocations to any single stock, fund, and sector will lower specific risk in your portfolio. This lowers your portfolio volatility without lowering your expected returns.

3. Valuation Investing For Individual Investments

Even if you get your asset allocation and diversification where you want it; if you get the 3rd one wrong it will be an exercise in futility. Selection of individual investments should be based on valuation. A value investor’s form of market timing is valuation timing.

Valuation timing means you own assets that offer a margin of safety. The margin of safety you require will determine your probability of success. The larger the required margin of safety the higher the probability of an above average rate of return. Purchasing investments with no, or even a negative, margin of safety increases the probability of losing your investment capital.

You can buy great companies who perform just as you expect but lose money because the price you paid was too expensive. On the flip side, you can buy companies where unexpected problems arise but you make money because the price you paid provided a margin of safety.


“High quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them.” Howard Marks


Stop trying to outperform the market and instead concentrate on buying assets at prices that put the odds heavily in your favor for a positive outcome. Then exercise patience. Sometimes, when investment assets are expensive, it means holding a large percentage of your portfolio in cash. Then exercise patience. Keep reminding yourself how devastating it is to lose your principal.

It is not my goal to outperform the market. My goal is to build wealth.

The probability of outperformance in the long term is greatly increased by minimizing loss of principal when the market declines. I do not worry about the years the market is advancing and I may be underperforming the market. That is the price you pay for refusing to lose your capital.

Investment Risk Management Plan Summary:

Investment risk is the most crucial concept in investing. Investors need a risk management plan that prevents a permanent loss of capital through the use of asset allocation, diversification, and valuation investing.

Related Reading:  5 Portfolio Risk Management Strategies

Minimize Large Portfolio Drawdowns

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While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.

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