We don’t invest our money to lose it.
Most of us know going in that markets can be surly and volatile, but we buy the stock or the bond or the fund anyway, and realize that one way or another, someday we are going to sell it. The need or desire to sell your investment presents itself for many reasons: I made a bundle so its time to cash in, I didn’t keep enough liquidity, I’m repositioning assets, I’m scared as hell and I’m not going to take it anymore, and so forth.
Whether you’re a reactionary seller, or one that sets a price target for your stock the day you buy it, it helps to know that you may be facing losses one fine day, and knowing about “loss math” or “break even math” may help to ease the shock when you are faced with red ink.
When those disappointing numbers are staring back at you it’s really not unusual for the emotional shorthand to kick in. “I’m smart, not dumb, like people say, so I lost 20%, but I at least break even when it goes back up 20%. Right?”
Not so fast, Fredo. Do the math.
That 20% loss requires a 25% gain just to get back to even.
It gets progressively more terrifying from there.
A 25% loss requires a gain of 33.3% to break even.
If you lose 50% you have to earn 100% to just break even.
And don’t forget, we’re talking just to BREAK EVEN, as in, back to zero, which really isn’t really a break even point at all, given inflation, erosion of purchasing power and opportunity cost. From that point, you will need a parade of green arrows on top of the break even to make real net positive returns.
…If you lose 50% you have to earn 100% to just break even…
For a recent historical example, look no further than the financial crisis of 2008 that led to the Great Recession. Deregulation of the financial industry allowed Wall Street banks and hedge funds to do some very “creative” financing with derivative contracts tied to mortgages. (Go read the history if you are unfamiliar in Michael Lewis’s book, or see the dramatized events in the movie The Big Short.)
The S&P 500 was down in 2008 (-37%). At a 37% loss your portfolio has to earn back almost 58% just to break even. In rough numbers, it took investors until the end of 2012 just to break even.
Sadly, many investors, especially older investors, were so spooked by the events they bailed out forever, at a loss, and missed the market bounce back since then.
So how do you avoid these scary numbers?
For starters, adopting a strategic asset allocation strategy using passive exchange traded funds to achieve proper diversification and risk parameters would be a great start to bring some financial sanity into your life. You do not have to beat the market to be an intelligent investor.
You should craft an allocation strategy that addresses the reasons you are investing in the first place, namely to achieve your financial goals, and start to establish some time frames and risk parameters.
With your game plan in hand, research and select a solid mix of individual correlated and complimentary exchange traded funds to build a portfolio designed to satisfy your strategic financial plan, model allocation and location strategy. And while you’re at it, start to think with the end in mind, and develop some price targets if you desire a more tactical approach to generating returns, depending on your age and time horizon.
Price targets aside, successful investing is not about trading; its about building sticky wealth using strong but flexible portfolio management policies using high quality, low-cost, diversified building blocks, and let your returns compound over the long haul.
After all, its about time in, not timing.