As the market continues to erase every pullback in short order, investors are focusing less on downside risk and more on  upside potential. Controlling losses is no longer a priority.  As the markets heat up, investors want a piece of the action. 

As contrarians, that isn’t our approach, and it shouldn’t be yours, either. Ideally, concern for downside should rise along with the market, just as ensuring you’re positioned for the rebound should be your objective during a long bear market. 

One way to temper upside exuberance is to look at your portfolio’s performance during the worst months for the stock market in recent years. Although performance during a  –4% month may not indicate how you’ll do in a –40% year or two, it can give you an idea of the risk you’re taking, and whether that risk is right for you.

The bad month test can also highlight your portfolio’s downside performance versus upside performance. At a minimum, portfolios should fall about the same on the way down as they do on the way up. If you’re losing half as much as the market on the way down, you’re probably gaining about half as much on the way up. 

We try to shoot for unequal returns – a little more upside than downside. Over time, this should be a winning formula (and has been, thus far.) More importantly, it creates a portfolio you can live with when the market turns bearish. It’s important for your portfolio to keep you in the game when the going gets rough (as it invariably will).

The trouble happens when a portfolio has unequal returns in a bad way, meaning more downside then upside. This can result from poor investment selection, like chasing past winners, and from paying too much in fund fees or to advisors to pick your funds. 

An expensive portfolio will almost always fall disproportionally to the increases as the expenses weigh on returns, both up and down.

For example, imagine if your portfolio were  50% in Expensive Stock Fund A with a 2% annual fee, and 50% in cash, earning zero. If the market goes up 10% in a year, you’ll earn a mere 4% on the way up — and only if the stock picks were as good as the market (often a big “if.”) And if the market falls 10%, your total portfolio return will be -6%, since you’re paying a 2% fee on half of it.

Our goal of more upside than downside isn’t required for you to do well over time (and quite frankly, isn’t always achievable, although so far, so good). You can just stick to, say, 70% of the market’s upside permanently with some aggressive balanced index fund, and you’ll do fine. Besides the fee bite, increasing your stock allocation on the way up can hurt.

The bull market we’re in now started in March 2009 following a bear market that was even worse and more broad-based than the 2000-2002 slide. Since most of this period has been up, you really have to go back a few years to find some bad months that are significant enough to review downside.

For the S&P 500, with dividends in this bull market, the worst two months saw roughly a 7% drop in September 2011 and a near-8% drop in May 2010.

Those were also our Aggressive portfolio’s worst months. It fell - 4.16% in September 2011, and in May 2010, just under 7% - not far from the market’s downside, though we lowered our risk level around that time (mid 2010) to reduce future downside, resulting in the lower drop relative to the market in 2011. If the market became more attractively priced, we’d likely return to the stock allocations we had in 2009-2010, which had higher upside, but also a greater percentage of downside.

Over the past 12 months ending in July 2014, the S&P 500 was up (with dividends and without fees) about 16.75%. During this bullish stretch, our Aggressive portfolio gained 10.77%, and our Conservative portfolio was up 9.94%. For the record, our portfolios fell by less than half of the market’s decline in 2008, the last major calendar year slide in stocks.

In recent years, we delivered about 2/3 of the market’s return at maybe a little over half the risk in our Aggressive portfolio, and well under half in our Conservative portfolio.

True, this this isn’t a terribly sophisticated analysis. One area it doesn’t capture is how much our downside may climb if interest rates go up. But running a similar check on your portfolio can give you an idea of what to expect when the market runs out of gas.

This favorable ratio may not repeat forever, but we seem to have a decent margin of error over just similar upside to downside, itself a solid goal.