How to Estimate Potential Losses

[Deleted User]

Linton said:

IMHO You really need to accept that the future is unknown. No amount of statistics is going to help predict what will happen in a major crash initiated by some external event.

My metric is simply the % allocation to any particular category of possibly correlated equities. If you minimise this you will get some protection barring a complete global collapse.

There is no question about that, of course I already do. But I do want to ensure that I understand the subject matter suffiently well and that I fully exploit known metrics. It seems to me there is a large proprtion of amateur investors who have no idea what the risks are in their holdings yet many of them say they want to explore the possibility of risk reduction measures.  Evidence for this is the extent to which investors hold trackers whilst expressing concern at Tech concentration and without understanding that they offer no downside protection. I for one want to ensure I fully understand my holdings and that I've taken every reasonable step to enure risk is minimised, based on my current knowledge level and before Mag 7 does sink.

OldScientist

A goal based approach is perhaps one way to start. In retirement there are probably two overall (competing) goals 1) sufficient income to support 'lifestyle' and 2) potential legacy

Risk is then defined as 'risk to goal' of which portfolio risk is only one component.

To take an example, a retiree might have sources of guaranteed income (state pension, DB pension, annuities, inflation linked gilt ladders) none of which have market risk, or inflation risk if inflation protected, but all of which have risk in other forms (e.g., political risk with the SP, debt default with the DB pension, annuities, and ladder) most if which are unquantifiable.

Market risk for the portfolio is then dependent on what investments are discussed. Equities have well known risks (largely volatility), bond funds have interest rate risk (which depends on duration) and inflation risk (at least for nominals) both of which lead to volatility in returns, property and commodities (including gold) have another set of risks. The aim of diversification is to offset these risks (although this has not always been successful).

Historical data (going back 100 years and more) allows some understanding of the volatility of complete markets (I'd count recency bias as anything less than about 60-70 years!) so the range of non-catastrophic outcomes (e.g., drawdown) can be estimated or notable crashes (GFC, 1929, etc.) can be used as worst case exemplars.

Linton

chiang_mai said:

Linton said:

IMHO You really need to accept that the future is unknown. No amount of statistics is going to help predict what will happen in a major crash initiated by some external event.

My metric is simply the % allocation to any particular category of possibly correlated equities. If you minimise this you will get some protection barring a complete global collapse.

There is no question about that, of course I already do. But I do want to ensure that I understand the subject matter suffiently well and that I fully exploit known metrics. It seems to me there is a large proprtion of amateur investors who have no idea what the risks are in their holdings yet many of them say they want to explore the possibilioty of risk reduction measures.  Evidence for this is the extent to which investors hold trackers whilst expressing concern at Tech concentration and without understanding that they offer no downside protection. I for one want to ensure I fully understand my holdings and that I've taken every reasonable step to enure risk is minimised, based on my current knowledge level and before Mag 7 does sink.

I think it is a mistake to be thinking about specific mitigation of possible failures with the Mag 7. Anything could happen anywhere at any time so everyone with life changing investments should have a long term ongoing strategy for managing systemic risk no matter where it arises

[Deleted User]

Since retiring over 20 years ago, I have seen two of my low and very probability risks materialse. The first was where my US Social Secuirty benefits were cancelled after 15 years, by Musk's DOGE team....subsequently reintstated following appeal but it took several months, which made for uncertain times.  The second was the UK governements attack on landlords which twenty five years ago seemed very improbable. Today, my concern is to protect my legacy hence I've learned to expect the unexpected so I take risk management seriously. At the same time I try to have fun with my investing hobby and make gains where I can. Hopefully, others who are reading this thread will benefit from the things that have been said. 

Alexland

chiang_mai said:

But what I did get out of this discussion is the need to evaluate performance over longer periods. I didn't think that that a few years might be regarded as recency but I can now understand the argument that it might be. 

OldScientist said:

Historical data (going back 100 years and more) allows some understanding of the volatility of complete markets (I'd count recency bias as anything less than about 60-70 years!) so the range of non-catastrophic outcomes (e.g., drawdown) can be estimated or notable crashes (GFC, 1929, etc.) can be used as worst case exemplars.

Yes anyone only looking at the past ~15 years of equities or the ~40 years of bonds leading up to 2022 would likely be suffering recency bias influencing their decisions. These periods were heavily influenced by the ramp down to near zero interest rates and the GFC equity market crash and ran for so long there is a generation of investors who probably considered it normal and even more who might have expected it to go on forever.

I'd built my long term plans on the pessimistic assumption that some of the assets I would need to hold in my portfolio during retirement might give negative long term returns which is why I am so pleased yields have improved and have taken the opportunity to lock some in long term. I'd been delaying buying them as they were so depressingly unattractive.

For those already holding bonds they have painfully returned to historically normal valuations but equites have defied gravity (despite near zero interest rates ending 3 years ago) similar to the cartoon physics in Road Runner when Wile E. Coyote runs off a cliff and is suspended in air while he looks down having a moment to think about what's about to happen. It seems to be a combination of momentum and expectations of continuing strong earnings growths holding up the market but that's hardly the most stable of foundations.