When it comes to investing, everybody thinks about progress in terms of returns. This makes sense since without them financial goals are much harder to achieve, but very little time is spent thinking about losses and the role they play in achieving (or not achieving) those longer-term returns. Even when looking at most financial plans – whether simplistically crude or detailed – usually there’s some assumption for returns achieved based on a pre-determined risk tolerance. Aggressive investors usually assume higher returns while those with a more conservative predisposition will assume lower, safer returns. We’ll address the fatal flaw of assuming that aggressive equals greater return another time, but the point here is that the focus tends to be on the return even though losses often times determine whether or not that return is even possible. Losses get no respect, but they should.
Here’s why they should and why investors should always think about how losses could impact their long-term return assumptions. First, the math behind losses works differently than most think. Since after a loss, one is left with a smaller amount of money than before, it takes a larger subsequent gain to get back to even. Not a big deal with small losses, but for larger ones the math gets crazy. A 10% loss requires an 11% gain to mend all the losses, but a 50% loss requires a 100% gain to make one whole again.
For example, if we start with $100,000, losing -10% leaves us with $90,000. To gain that $10,000 back from a new base of $90,000 requires an 11.1% return. Bring that loss to -50% and our initial $100,000 investment drops to $50,000. Gaining that lost money back on our new, significantly lower base of $50,000 necessitates a 100% return. Take it to a 60% loss and we’re looking at a 150% gain to get back to even! Getting back to our $100,000 starting point from $40,000 demands a $60,000 investment gain. Yikes. Just to highlight how damaging this particular scenario would be, think about the fact that the additional 10 percentage points of loss (from -50% to -60%) would require an additional 50 percentage points in gain to get back to where you started (100% to 150%). It can take years to make 50% in markets whereas a -10% loss can happen within days. Investors who don’t take the time to grasp this concept are at risk of experiencing it first-hand.
In the real world, we’ve seen countless examples of this math play out throughout history. Most frequently markets experience smaller losses of the -5% to -10% variety. As we’ve discussed, these aren’t a big deal. They’re par for the course, to be expected, and easily recovered from. However, the largest of losses throughout history have been at the end of very prosperous periods where markets have performed at their best. These losses tend to be of the -50% or larger variety. These are problematic and extremely destructive when it comes to subsequent portfolio returns. One of the most recent examples is the dot com bubble of the nineties. When it popped, the S&P 500 dropped -50% and took roughly 13 years to recover. Worse, it took about 24 years for the Dow Jones Average to recover from it’s 89% decline that began in 1929. That’s a 0% return between 1929 and 1954! Keep this in mind; for an “aggressive” investor assuming a high return this 0% couldn’t be farther from what he or she had in mind. The large loss up front destroyed any hope of averaging high returns going forward.
It’s also instructive to look at how large losses can wipe out gains that investors have already achieved. By late 2008 after a -56% loss in the S&P 500, 127% of gains were wiped out taking the index back to where it was in late 1996 – 12 years prior. Going back to our extreme 1929 example, that -89% drop took the Dow Jones Average back to 1903 by wiping out ~800% of gains! That’s 26 years of progress…gone.
Think about it this way. When markets are valued somewhere in the middle of their historical range, large losses are less likely. Investors will undoubtedly encounter lots of the smaller losses and even a few stomach-turning ones, but history has shown us that these losses probably won’t last too long. Stock markets are generally predisposed to rise over time along with economic growth. However, and this is crucially important, when markets are valued expensively relative to their historical ranges, the likelihood of large losses goes way up. In fact, you’d be hard pressed to find a time in history when any asset market that’s been extremely expensive hasn’t come back down in price in dramatic fashion. You simply don’t get the abnormally large ups without proportionally large downs. Losses of this variety are incredibly destructive not only to investment performance by the time they’ve played out, but more importantly goals, lifestyles, and the ability to maintain financial independence. So please, take them seriously. Think about them just as often as you think about returns. They’re just as important a piece in the overall puzzle as returns themselves. They deserve respect.
