If you listen to very successful investors, a recurring theme is that people can make money in down markets. Although at first this may seem foolish, when you understand the reasoning, you can see that it is not only very insightful, but also very true.

What these investors are really talking about are two distinct methods to make a fact from their hypothesis. First, money can be made when the investor’s account declines less than the general markets do when they fall. Although this is not a direct gain in an investors account, preserving capital changes the “starting” value when markets start to rise. For example, if the markets go down 40% and the investor’s portfolio drops by 15%, then the markets climb by 40% and the investor’s portfolio increases by 25%, the end result is that while the markets are still down 16%, the investor’s portfolio is up 6.25%. By avoiding the broader market decline, the investor does not have to capture the full upside of the market to end up ahead!

Second, and more obvious, is that money can be made by taking advantage of investments (whether they be stocks, bonds, or other instruments) while they are on sale. Successful investors not only find, but invest in these bargains when others are fearful to do so. Think of Warren Buffet investing in Goldman Sachs and General Electric at the peak of the crisis. Investor psychology is driven by the two emotions of fear and greed. Unfortunately, this psychology typically has investors sell and buy at the wrong times.

One way to help an investor make money during the down markets is to ensure that portfolio risk level is evaluated properly and updated frequently. Investors should review their risk level at least once per year and during any significant life changing event (getting married, purchasing a home, having a child, retiring, et cetera). Since the answers to risk questions should change over time, especially in connection with a significant life event, an investor’s risk level should not remain static over time. A risk questionnaire can be a useful tool in this evaluation. Specific factors such as the investor’s age, or the time horizon until the money will be used, are important, but the key element in a good questionnaire is that it should help the investor put aside emotions about risk – it should assist the investor to clarify risk by taking out the fear and greed factors.

Once an investor’s risk level is properly assessed, the resulting portfolio should help the investor avoid making irrational decisions at inopportune times. During the past crisis, an investor whose risk level was on the mark, most likely was able to sleep better at night and take advantage of making money during down markets.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations. To determine which investment(s) are right for you, consult your financial advisor before investing.