Warren Buffet is quoted as saying, “Rule number 1 of investing is never lose money. Rule number 2 is never forget rule number 1.”
Not losing money (what we in the financial industry refer to as downside capture) is key to long-term financial gains, as any negative return totally negates compounding interest, and the higher the loss the greater the impact. Downside capture is especially important during the “High-Risk Window” — the 10 years preceding and following financial independence — since during this period of time it is difficult to replace lost money, either because of time constraints or the loss of earned income.
To demonstrate how negative returns can affect a portfolio, let’s look a few examples. In the table below we have invested $100,000. A loss is experienced in year one, followed by an equal percentage gain in year two. You would suspect that if you had a 10% loss in year one and a 10% gain in year two that they would offset and result in a wash, but this is not how the math works. In reality, the compound average return for both years is negative. I also included the simple average to show how the calculation can be misleading.
The table also illustrates the effects volatility has on a portfolio. The larger the dispersion of returns, the greater the drop in compound return. Historically, the riskier a portfolio the more volatility one should expect. If we imagine each of the examples as portfolios, with 1 being conservative and 3 being growth, we can see that a conservative approach can actually be more beneficial, especially in times of greater market volatility.
What is most important to point out is the percent required to break-even after a loss. As the loss increases, the return required to make up for it increases as a result of the negative effect of compounding. It would take a 100% gain to recapture a loss of 50% and a 300% gain for a loss of 75%! Over a long time horizon, such gains might be possible, but for those in the High-Risk Window, there simply isn’t enough time.
Because of the effects of negative returns, it is critical for those in the High-Risk Window to take a conservative approach with their investments. Unfortunately, the low-interest rate environment is making it increasingly difficult to find yield in traditionally safe investments, forcing many of today’s pre- and post-retirees to seek higher returns in more risk-prone assets. This leaves them vulnerable to higher volatility of returns, and possibly large losses, which could put their financial independence in jeopardy.
If you’d like to discuss how to preserve your wealth, feel free to schedule an appointment. You can read more about our investment philosophy here. To see how proper investment management can lead to higher returns, feel free to visit our performance page.
Patrick Daniels is the Financial Planning Analyst at Precedent Asset Management, serving clients as a fee-only advisor in the Indianapolis, Indiana area and nationwide, through coordinated financial planning and investment management.