What Is Downside Risk?
According to Investopedia, “Downside risk is an estimation of a security’s potential to suffer a decline in value if the market conditions change or the amount of loss that could be sustained as a result of the decline. Depending on the measure used, downside risk explains a worst-case scenario for investment or indicates how much the investor stands to lose.” (source)
In layman’s terms, the downside risk is how much money you can lose if all hell breaks loose with your investment or if the market drops out from under you.
It is easy to get caught focusing on the upside potential of an investment as opposed to the downside risk. The upside is sexier and more fun to think about.
Think about it—which sounds better?
“You could triple your money in a month!”
“You can manage your losses to ensure you don’t lose more than 2% this month.”
Obviously tripling your money is more exciting and feels much better…but which is more important?
Ironically, the most successful investors are those capable of managing their downside risk. It is much faster, easier, and more detrimental to lose money than it is to “win big” on an investment.
50% Lost Requires 100% Gain
Take a look at this chart. What do you notice?
If you have a hundred dollars and take a 50% hit one month, it leaves you with $50. If you then receive a 50% return on investment (ROI) the following month, it will only bring your investment value back up to $75. In the next month, you would need just under a 34% return for your investment to return to its original value.
In order to regain the original value of your investment after a 50% loss, you will require a 100% ROI on what is left.
Stated another way, if you lose 50% of your investment portfolio, your money must double (100% return) in order for you to break even.
Whereas it only takes a 33% loss to erase a 50% gain.
The previous scenario wouldn’t be so bad if the numbers worked both ways, but they don’t. Just look at this next chart.
If you have a hundred dollars and get a 50% ROI one month, it leaves you with $150. Not bad! If, however, you then take a 50% hit the following month, it will bring your investment value down to $75. In fact, it would only require a 33% hit in order for your investment to return to its original value.
It only takes a 33% hit to plummet back to the original value of your investment after a 50% gain.
Stated another way, if your portfolio jumps to 1.5 times its original value (50% ROI), it only needs to drop by one-third in value (a 33% loss) for you to be back where you started.
Hopefully, these charts made this concept easy for you to grasp, but long story short…your portfolio will drop in value much faster than it will grow with equal market gains/losses.
Protecting Your Downside Risk in Real Estate
Luckily! There are many ways to mitigate your downside risk as a real estate investor!
Even better, most of these are really simple, inexpensive things to do (which is one of the reasons I love real estate investing)!
You need to get educated before you do anything else. Ignorance is not an excuse when things don’t go your way with real estate. Take the time to learn, learn some more, and continue learning throughout the duration of your life.
The more you understand tax codes, landlord laws, financing pros/cons, and all aspects of real estate, the more you will be able to foresee potential issues and stop them from biting you in the rear.
The most important things for you to be educated on at the beginning (in my opinion) are analysis, due diligence (which has its own section below), and operations.
You need to understand the analysis completely. If you miss a single expenditure or account for more income than the property is generating, you could easily find yourself paying out of pocket to hold on to your “investment.”
Failure to understand operations (and budgeting for operations) when investing can lead you down a bumpy road. If you aren’t willing to educate yourself on operations, you need to hire a solid property manager.
Never. Stop. Learning.
This is a no-brainer. You need to ensure your real estate investments, just as you would a car, primary residence, valuables, etc. You can even insure your legs, voice, or MUSTACHE (Merv Hughes just became my hero for this). (source)
The great thing about insurance is that (almost) any outside factors damaging your property will be covered. That is a great way to protect your downside.
There are even insurance policies that will provide insurance for rental income. If your property sits vacant for too long, you could receive money from this insurance payment…talk about protecting your downside (although I believe this is an unnecessary expense).
Just make sure you insure yourself against the “what if’s” of real estate, and you’ll be glad you did! Insurance has saved me a couple of thousand dollars over the last few years!
Due Diligence Period
Due diligence is the make-or-break point in purchasing real estate. You need to understand what you’re looking for in order to ensure there aren’t a ton of underlying issues with the property you have under contract.
Within the due diligence process, you need to understand how to verify every single item on the income/expense report (and find items that may have been omitted).
Utilize your due diligence period to the max! This is your chance to “pull chocks” if there are issues with the property. If you discover issues with the property during inspection, you can ask the seller to fix them, give you that money at closing (my preference), or reduce the cost of the property.
I like to have my property manager walk through the property as well. Have them bring estoppel agreements (or their own method) in order to verify that what the tenants claim to be paying for rent matches what the owner is claiming they pay.
Don’t let your pride get in the way. If you discover irreparable issues, back out of the deal.
You need to understand how financing and equity play into your purchase to provide a buffer against market downswings.
Don’t over-leverage by purchasing a property with no equity. Equity is the main buffer you have against a recession. If the market drops 20% but you had 30% equity in the property, you aren’t below water.
However, if the market drops 20% but you only had 5% equity, you will be underwater until the property value increases or you pay off more of the house.
This doesn’t really matter unless you sell while you’re underwater, but it will mess with your head and is not a safe way to buffer against losses.
Also, the more equity you have in a property, the more cash flow it is likely bringing in.
My definition of cash flow is the money left over from your rental income after ALL of your expenses, including budgeting, have been taken out.
Cash flow mitigates your downside risk because no matter what the market does, it is fairly easy to hold on to a property that is paying you to own it.
If your property is struggling, simply reinvest this additional cash flow back into the property to help weather the storm.
To be clear, cash flow will not make your investment invincible…but it will definitely help.
Cash flow also allows you to save more money for capital and cash-reserves to help you prepare for when “ish” hits the fan!
Maintain Cash Reserves
Cash reserves exist solely to protect your backside in the event of a downturn.
Many investment banks require a certain amount of reserves to qualify for the loan. I applied for a loan once and was informed that I needed to have enough cash reserves to cover ALL of the principal, interest, taxes, and insurance (PITI) payments for 6 months! I didn’t utilize that bank, though I suppose that would ensure I was protected against downside risk at least. Haha.
The Thrift Savings Plan (TSP) counts towards your cash reserves. That is one of the reasons I love having money in the TSP. My money is benefitting from compound interest, and while it is growing, I’m also able to utilize it as cash reserves for banks. It’s also there if I HAVE to pull money out to make up for a huge unexpected expense.
I don’t recommend ever dipping into your cash reserves unless you have to…but they are nice to have when Murphy’s Law rears its ugly head: “Everything that can go wrong, does.”
Another great way to protect against disaster(s) with your real estate investment is to have multiple exit strategies. Going into the purchase, you should be thinking through these strategies.
Can you wholesale the property to another investor? Are you planning to fix-and-flip it?
Maybe you can refinance and hold it as a long-term rental? Or even sell it with a lease-option (rent-to-own) to one of your tenants.
The point is that there are a lot of different ways to exit a real estate investment without losing your house (figuratively and literally).
Plan ahead, and always remember that it is the creative real estate investor who wins in the end!
Protecting Your Downside Risk in the Stock Market
As many of you know, I much prefer real estate investing over the stock market. One of the reasons is that I believe that real estate has much better ways to protect you. Real estate investing is more tangible and less emotionally driven. Tesla, for example, lost something like 9% of its stock value when Elon Musk smoked a blunt on The Joe Rogan Show (source).
That is my least favorite aspect of investing in the stock market. Other people’s emotions play into the valuation of my investments. When my real estate investments suck…at least it’s my fault haha.
Logic > emotion
The first way for you to protect yourself in the stock market is to invest logically rather than emotionally. Don’t invest based on how you feel about the market.
When the market drops, don’t sell.
When the market rises, don’t buy.
This style of investing is reactive in nature, and you’re almost certainly too late anyway.
I know, “But David, if I don’t sell when the market is dropping, I will lose money.”
Yes and no.
You won’t lose a penny if you refuse to sell after the market drops. If it comes back up, you will be right back where you started and on the rise again! I know this is easier said than done, but that is why you shouldn’t listen to your emotions when investing.
Also, if you are waiting until the market drops to protect yourself against it, you are probably too late anyway. You don’t know if it is going to drop by 10% and then rise by 20%. If you sell in this scenario you would lose money! Or perhaps it drops 10%, then 10% more, and then 40% more…but if you didn’t sell, when it comes back up, you’re right back where you started.
A method to mitigate your losses in a downturn is with a put option. Put options allow you to purchase the right to sell at a given price point, even if the market drops.
For example, if I buy a put option to sell XYZ stock if the price drops 10%, and the stock market drops 40% in four days, I can execute my option, and sell the stock at only a 10% loss.
Put options are a great way to protect yourself against large losses, but they have a downside too. It costs money to buy put options.
Let’s say it costs 1% of the stock value to purchase a put option, and the stock doesn’t drop within that window (they have a shelf life). In that case, you are guaranteed to lose 1% or the cost of the put option.
Is risking 1% worth avoiding a 40% drop? Sure…but how often does the market drop 40%, and are you that confident in your prediction abilities?
What if you buy 10 put options and execute none of them? That is a 10% hit to your portfolio and might erode any gain your portfolio experienced in this time!
Put options are good but are definitely a more experienced investing strategy.
Invest in the Company, Not the Chart 🡪 Not Penny Stocks!
I know all the day traders are about to hate on this point…
Look, I get it. Day trading is fun, sexy, and can be lucrative.
Any good day trader will admit that they are investing based on what the charted, daily-market fluctuations look like and not the actual company. They are literally betting against the emotional buying and selling of other investors.
That is all well and good but not how you want to invest in the long run. There are a lot of other reasons I am not a fan of day trading (time, tax implications, fees, lack of passivity/dividends, etc.), but that is neither here nor there.
The best way to buy individual stocks is to invest in companies that you believe to be future-proof. Companies like Amazon, Apple, Microsoft, Google, etc., will most likely be around for a long time. Logic says that as their companies grow, so will the value of their stocks. Therefore, they will be much safer than investing in a company you don’t know anything about that may, or may not, be able to withstand a recession.
Dollar-cost averaging is another great way to remove emotion from your investments.
Using this strategy, you will invest $100 in the stock market month over month, no matter what the market does. That way if the market drops you are buying more stocks at a lower price and vice versa. By consistently investing and not reallocating your portfolio more than once or twice a year, you will avoid making emotionally-driven decisions.
Index funds are a conglomerate of stocks.
This is another great way to invest long term because you can purchase a total stock market index fund.
That means you’re investing in the entire economy rather than just one company. In the long run, this is a good way to protect your downside and stay hands off!
Protecting Your Downside Risk as a Mindset
Mindset is so critical to your success in life.
You need to adopt a mindset that is more worried about protecting against downside risk than it is excited about upside potential.
Logic > emotion
Again, the name of the game is investing logically, not emotionally.
Emotions are fickle and will get in your way. There is no easy way around this, so you need to protect yourself against emotional involvement as proactively as possible.
I like to conduct a simple analysis of real estate investments before I even look at pictures of the property. That way, I guarantee there is (almost) no emotional attachment to the property. The last thing I want to do is begin daydreaming about what it could look like when I’m done renovating.
The less you think about the property and the potential reward before analyzing, the better your analysis will be.
In general, if you are feeling super excited, stop yourself and ask if it is interfering with the numbers.
Remain as emotionally detached from your investments as possible.
You hear me say it all the time, but never stop learning.
The fastest way to hedge downside risk is to become an expert in your chosen asset class. This goes for anything you do in life. The more educated you are about it, the better you’ll perform.
Over the last two years, I have paid for books, courses, and/or coaching for writing, social media marketing, YouTube growth, podcasting, and of course tons of content on real estate investing and entrepreneurship. I practice what I preach here.
It is much easier to learn from those who have gone before you than it is to learn as you go. Trust me, I’ve done it the hard way too many times!
Trust But Verify
Always verify what others are telling you about a potential deal.
A prime example of this is a property I almost bought in 2016. As we were negotiating the contract, the seller had informed me that the tenants paid the utilities. He stated that they were around $400/month for this duplex (combined).
When I pulled the utility report from the county, I realized that not only was the landlord paying the utilities, but it was closer to $600/month for the duplex.
Right there, I dodged a bullet.
You see, the numbers on this property looked pretty good at first. But when I factored in an additional $600/month for utilities, it no longer made sense. Sure, I could have instituted a ratio utility billing system (RUBS) to combat this, but it would have been a much larger headache than anticipated.
Moral of the story: always verify the seller is not misinformed or, let’s be honest, lying to make the deal sound better.
Trust Your Gut
Malcolm Gladwell wrote an incredible book titled Blink: The Power of Thinking Without Thinking that is all about trusting your gut instincts.
Did you know that within 5 minutes of talking to somebody, you can judge their character with a 70% rate of accuracy (source)?
Not too shabby!
Now, your decisions may be biased by how attractive that person is, their gender, etc., but you can train yourself to avoid these.
It is a fascinating book and will help you understand when and how to trust your gut.
With investing, I would say that more often than not, your gut instinct is right. I know for a fact that I could have avoided some growing pains if I had trusted my gut more in some of my early investments.
Downside Risk Be Gone!
This can all be boiled down to three simple concepts.
- Invest logically, not emotionally. Emotion does not belong in business.
- Be proactive, not reactive. Pay for insurance, have exit strategies, and plan ahead.
- Focus more on how to mitigate downside risk than how to increase upside potential when buying.
As Warren Buffet once said, “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1” (source). Now get out there and don’t lose money…oh yeah, and make some money as a result!