There are many different types of investment risk – some more dangerous than others – but they tend to get rolled up into a single generic term – “Volatility Risk” which describes the difference between the returns you expect to get and what actually happens over time.

While almost universal in it’s use by investment managers, Volatility Risk is a poor proxy for the kind of risk that matters to investors. It equally weighs Upside and Downside risks, but Upside Risk isn’t a problem for most people.

Would you complain if you made more money than you expected? Me neither. It’s the Downside Risk that gets people upset when it’s realized.

Because most traditional portfolio designs use “Volatility” risk, they mute gains as they try to manage potential losses. Getting lower but more consistent returns with less volatility would be OK if clients and investors were completely rational, but you’re not. You’re human and that means prone to emotional reactions.

Even more challenging – your performance expectations are heavily influenced by what’s going on around you. Think of a 10% loss on your portfolio in the context of two different scenarios: (1) the market gains 32% (2013) or (2) the market loses 38% (2008). If the market is doing well, you want to do well and that 10% loss is upsetting but that same 10% loss looks pretty good compared to a market where everyone else is losing a lot of money.

There IS a limit to this “Happy Loss.” You’re likely OK with losing some money as long as others are losing more, but only up to a point. That point is your Draw-down Pain Threshold (DPT) – the amount of loss that regardless of what your neighbors are experiencing would cause you to lose sleep overnight.

Typically the DPT is between 12% and 20% but each case is different. Effectively managing investment risk means avoiding “the Big Loss” (which can devastate your family’s financial future and make your own life miserable).

Learn More About the Big Loss (Blog Post)

Our primary focus in managing client portfolios is to manage downside risk (especially exposure to the Big Loss) and we do it without significantly affecting upside potential. These are techniques that are beyond the scope of this article, beyond the abilities of most retail investors and frankly ignored by many investment advisors we’ve met.

The first step for you is to understand the amount of investment risk exposure (especially downside risk) built into your current portfolio and to make sure it matches both your current expectations as well as your Draw-down Pain Threshold (DPT).

In 4 out of 5 cases, it won’t.

Try the Portfolio Risk Inspector (it’s FREE!)

After that, you can have a conversation with your investment manager about where the bad risks are in your portfolio and how those risks are being managed. Does he/she have an exit strategy for the next market correction? If you don’t get a response that you like in that conversation, it’s time to change advisors … even if that means firing yourself.