What is your level of investment risk tolerance? Can you afford to lose?

When planning your financial future, make sure to take the possibility of loss into account.

Even though Warren Buffet has billions of dollars at stake in Wall Street, if the market tumbles again, he will still have a secure retirement. Yes, he will have paper losses, but chances are that they will not cause him to go to bed hungry.  Compare that to the woman who called me recently who had a clear understanding of the current economic state of affairs. Based on her analysis, she thought that world stock markets were poised for a second dip. It turns out that almost all of her money is invested in stocks, and she has hardly any pension. So why didn't she sell off some, or even most of her stock positions? "I can't sell the stocks that have gone down because then I will lose money."  The fact is, I explained, she has lost the money already.

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And if she thinks the stock market will drop further, she will lose even more.  There are other suitable investments that she could have chosen.  Even if bonds and money market investments aren’t as glamorous as stocks and may not have as large of a potential for gain, the fact that there is less risk involved may make them a more appropriate investment. 

The lesson here is twofold:

 The fact that a stock has declined in value is not a reason to hold on to it.  While it may be painful to acknowledge that your stock pick wasn’t a success, it may be even more painful to continue holding onto losers.  At some point, it is productive to cut your losses and re-evaluate investments.

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If further drops in your portfolio will jeopardize your future, you need to reconsider your asset allocation and possibly sell your stocks (and stock mutual funds).

While there are ways of structuring your portfolio to minimize losses (diversification strategies, asset allocation, buying puts, etc.), before investing in stocks, you must be aware that there is a chance that you will suffer a loss of principal.  While the Warren Buffets of the world may be able to sustain real losses, if you cannot, either because you won’t be able to sleep at night worrying, or you won’t be able to pay your bills if your portfolio shrinks, consider meeting with your financial planner to discuss which investments are appropriate for your risk tolerance. 

  

Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.