It almost goes without saying that emotional behavior leads to irrational and impulsive decisions that HURT your investment results. Just look at the Magellan Fund that Peter Lynch ran at Fidelity. This was the most successful mutual fund in history while he was there, averaging 20%+ returns every year for nearly two decades yet according to Fidelity, half of its investors lost money in it.
The best way to determine your comfort level is to understand how much you are risking. They call this in the investment world, VAR (Value at Risk). Now there is not a simple way to do this. It’s unscientific but it will work for most people. Don’t invest over 2 or 3% in any one idea. It’s not likely that a stock will go down 50% in one day but it does happen. So if one of your positions went down 50% and it represented 2% of your portfolio, well that’s a 1% loss in your overall portfolio. 50%*2=1% overall. Now if you have a 50% position and it goes down 50%, well that’s 50%x50% or a 25% overall loss of value of your entire portfolio. That’s probably an unacceptable risk. It certainly is for me.
There’s a more sophisticated way of doing this, though. It’s called VAR (value at risk) A technique used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatility. If you have a portfolio that can go down 20% in a day, you are probably not sleeping well. You can determine the likelihood of how much up or down your portfolio can swing any day by calculating the average beta. The way we do this is simple enough. We will discuss that in detail on the post on Beta. If you have too much volatility for you, then you are NOT sleeping at night.
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