One pitfall of looking at investment performance in the rear-view mirror, is a tendency to gloss over bad times and focus on total return over the holding period. Invariably, the distress felt when markets do plummet is not fully imagined from historic data, especially when (as is the case with shares) past gains are impressive over the long term.
Understanding capacity to absorb a big loss is one of the starting points in deciding investment strategy. A sensible way to look at this is in terms of the size and frequency of losses a portfolio can be potentially exposed to, given the timeframe the investor is hoping to be rewarded in. For example, a person in their 20s could, in a bad year, probably bear a 25 per cent drawdown in the value of their pension fund, knowing it has 40 years over which to meet its target annualised return. If the objective is something more immediate, like buying a house in five years, then such a loss is unacceptable.
Therefore, an investor needs to consider not only their required future return but also the level of risk they are prepared to take. When plotted on a graph, the line depicting the trade-off at different levels of absolute risk tends to slope upwards. In theory, an investor should be prepared to hold a portfolio represented at any point along this line, so it is known as their 'indifference curve'.