The goal of an adequately diversified portfolio is to avoid suffering large losses by having too much exposure in one holding, industry or asset class. If you are taking some risk with your investments, it is unrealistic to avoid losses (at least temporarily) over various cycles in the markets. However, it is desirable to keep those losses to a reasonable level. Large losses require even larger gains to get out of the hole and back to breakeven.
For example, it takes an 11% gain to make up for a 10% loss. Not too daunting, but as losses get larger, so do the gains required to fully offset the losses. A 25% loss requires a 34% gain to make your money back. A 50% loss (as many aggressive investors suffered in 2008) requires a whopping 100% gain to get make your money back.
When investors suffer large losses it becomes more emotionally challenging to stick with holdings and a portfolio that delivered such a staggering loss in the first place. Fear is a strong emotion than greed. Large losses can make you seriously question your investment plan and tempt you into making the wrong move at the wrong time. Or, large losses may drive you to take even bigger risks to make your money back, putting your remaining principal and financial well-being in doubt.
The key is to figure out what kind of volatility you can live with at the outset and not deviate too far from a portfolio that historically has resulted in those losses. When markets are going well it is easy to get complacent about risk taking. You need to be confident that you are positioned properly so when volatility strikes you are comfortable and not tempted to bail on your investments.
Many factors need to be considered when building a portfolio that’s right for you. Your age, time horizon, income needs, tax situation, household income, are some of the key things that need to be considered.