Tuesday, January 19, 2016

What Will It Take to Earn Your Money Back?

What Will It Take to Earn Your Money Back?

Understanding the Math of Recovering from Losses....

The market declines of the past two weeks have investors everywhere licking their wounds and toting up their losses, even as they prepare for the possibility of more losses to come.

But what, exactly, will it take to make up those losses? 

Many people underestimate the gains needed to recover from big investment losses, and the extent to which additional losses put you deeper in the hole. Amid all the current market gloom, it's worth taking some time to understand what it might take to recover from the current market swoon.

Everyone knows the stock market has its ups and downs, but just what's involved in recovering from a serious down? If you lose 10% one year but your portfolio returns 10% the next year, are you even again?

The short answer: no. The math of recovering from a loss isn't quite that symmetrical. You have to gain more than you lost to recoup all your losses. To understand why, let's look at a hypothetical example. Say you have a $50,000 portfolio. In Year 1, you suffer a 10% loss and are down $5,000. That leaves your portfolio worth only $45,000.

In Year 2, the market rebounds and your portfolio rises by 10%. However, that 10% increase is based on a $45,000 portfolio, not $50,000. That means the 10% return adds only $4,500 to your portfolio, not $5,000, leaving you still $500 down from where you started. You would actually have to earn a return of a little over 11% to get back to your original $50,000.

The bigger the loss, the bigger that rebound needs to be to get you even. For example, if that $50,000 portfolio had taken a 40% hit, as many did in 2008, you'd need almost a 67% increase to offset that $20,000 loss and get back to the original $50,000. That could take several years even if stocks perform well.

The challenge is compounded by investor psychology. Adjusting your asset allocation to aim for a higher return is one way to try to recoup losses faster. However, many investors find it difficult to take on additional risk after having watched their investments take a hit. And there's no guarantee that more risk will necessarily produce the desired result--at least not within the desired time frame.

The lopsided nature of recovery from market losses underscores why risk management is such a key component of successful portfolio management. Being realistic about the level of risk your portfolio involves and how much time you have to come back from potential downturns may help increase both your emotional and financial resilience.

The pillars of maintaining your wealth:

Risk management
Dynamic asset allocation
Thorough security selection

These pillars in turn help you achieve the downside protection / absolute returns and are key in maintaining your wealth.

The diagram below, whilst obvious from an arithmetic perspective, is extremely illustrative of the importance of preserving capital: once lost, it is very difficult to make it back.

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