Motley Fool: How much could you lose on shares?

Now, investing academics use the word ‘volatility’ to describe these ups and downs in share prices.

They also use the word ‘risk’ to describe the same thing.

I’ve never met an investor who decided their shares were ‘too risky’ because they were going up too fast. On the contrary, outside of the ivory towers of academia, the risk is losing money.

And that only happens when shares we own go down.

You may think I’m stating the obvious here, but an academic would probably take issue with me. And in a way they have a point. You see, too often investors think they can have it all – that they can have their cake and eat it, and not suffer any metaphorical indigestion. But shares don’t work like that.

The whole reason shares have beaten cash and bonds over the long-term is because they go down as well as up, and most of us can only take so many downs.

This means that instead of owning only shares – which over the long-term would be expected to deliver the highest return of all assets – we spread our money between cash, bonds, property and so on.

In fact, if we really didn’t care about the downs in our quest for the ups of investing, we might even only buy the riskiest shares in the stock market.

Typically these would be small-cap value-style shares, which as a class have smashed the returns from larger companies over the very long term.

But most of us do care about the downs. We can only take so much volatility before we feel queasy – and small-caps can be very volatile indeed. Therefore we spread our bets.

The trick is to get a sense for how much downside you can take well in advance of when you’re tested. That’s the ideal. But in reality, people – especially new investors – tend to forget all this stuff in a bull market.

In a bull market, everyone feels like a genius. Nobody cares about the downside.

From the start of 2009 to the start of 2014:

• The FTSE 100 advanced 60 per cent.

• The share price of microchip designer ARM Holdings rose around 1,200 per cent.

• Sports fashion behemoth Sports Direct advanced over 2,100 per cent.

• AIM-listed online fashion retailer ASOS saw its share price rise some 2,400 per cent.

These are hardly obscure companies. Yet their shares skyrocketed anything from 13-fold to 25-fold as we emerged from the financial crisis. If that isn’t volatility, I don’t know what is! But is it risk? I mean, it doesn’t look like risk when shares are rising. It’s a different story when shares fall.

Since the start of 2014:

• Sports Direct is down 16 per cent.

• ARM Holdings is down 21 per cent.

• ASOS is down 67 per cent.

In contrast the FTSE 100 has fallen 7 per cent. This is volatility – risk – in action.

In the cold light of day most of us would say we’d love to own a few 12-baggers such as ARM, even if it meant that sometimes we’d see our shares fall 20 per cent when times turned bad.

Even in the wake of a 67 per cent fall this year, ASOS is still an eight-bagger compared to where it was at the start of 2009. Logic dictates it’s worth taking the rough with the smooth.

If the bout of choppiness that hitherto high-flying companies have experienced in the past six months has you looking for an early exit, it leads me to suspect that you:

• Had too much money in shares

• Were over-invested in the most risky shares

• Didn’t really understand what you owned.

Figuring out your own risk tolerance isn’t easy, but it is definitely better done before you’re caught out. There’s certainly no one-size-fits-all approach.

If you’re very risk averse you might put just 20 per cent of your money in a tracker fund and keep the rest in cash, and sleep easily at night.

Most Foolish investors are probably more intrigued by the potential of individual shares than that, but there’s still a vast spectrum between spreading your money across a basket of solid companies compared to betting all your money on a handful of stocks in a single exciting sector.

I don’t even think there’s necessarily anything automatically wrong with the latter if you truly know what you are doing – and the huge gamble you’re making.

What’s important is to think about risk and how much money you could lose – not when the market is already down, but rather when your portfolio is flying high and you can’t help expecting even more gains.

Seeing your portfolio marked down 20 per cent in a bad year will never be pleasant. And if it means you can’t sleep at night, or there’s a chance that in a bear market you’ll sell all at the bottom and stuff your cash under a mattress then you’ve learned something important about your attitude towards risk. Remember it.

That way the next time the sun is out and making money seems easy, you’ll hopefully think to take some off the table.

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