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The Arithmetic of Loss

Legendary investor Warren Buffet is often quoted as saying “The #1 rule of investing is… don’t lose money”. Most people regard this remark as being somewhat tongue-in-cheek. After all, who wants to lose money? However, I think Mr. Buffet was actually quite serious. In fact, I believe it is absolutely critical for every investor to understand the importance of this fundamental, but largely overlooked, truth.

Unfortunately, we’ve been taught to believe that the only thing that matters is long-term results, and that short-term volatility is a necessary and unavoidable consequence of this pursuit. Quite the contrary, my experience suggests that avoiding losses in the short term is paramount to achieving success over the long-term. To demonstrate this concept, let’s take a look at a simple mathematical example.

Let’s say you have a $100,000 portfolio and you lose 50% in year one. Then, let’s say you gain 50% in year two. The commonly accepted industry math would tell you that your average rate of return over that two year period was 0%, which might not sound so bad to someone who is hoping to average, say, 5% or 7% over the long-term. However, closer examination reveals that your portfolio is actually now worth only $75,000! The same holds true if you gained 50% the first year, then lost 50% in the second year. Either way, you still have a portfolio worth only $75,000!1

This same principle holds true regardless of whether we use 50% or some other percentage, say 10%, as our example. The bottom line is that losses hurt your portfolio much more than equivalent gains help your portfolio. This is because the losses come as a percentage of a larger total. This is why it’s so difficult to recover from the kinds of losses many people have experienced during the extreme volatility of the past decade.

Another take-away from this example should be that average rates of return, in-and-of themselves, mean very little. A much better measure of success is the actual amount of money in your portfolio! As simple as this may sound, the financial industry has done an exceptional job of keeping our eye off the ball by training us to focus on the long-term as opposed to the short-term, which, as previously stated, is the primary determining factor for long-term success! So why does Wall Street want us focused on the long-run? Common sense suggests the incentive for Wall Street is clear: the more focused we are on the long-term, the less critical we’re apt to be of the short-term.

Compounding the issue is the fact that as we begin to rely more and more on our investment portfolio for supplemental retirement income, we must consider the impact of the order of returns. The reasons for this are twofold. First, we have less time to recover from losses. Second, we are removing principle from our portfolio, which means it is no longer available to grow. Here’s another example to help illustrate this concept.

Let’s assume two people retire, each with $1,000,000 invested in the S&P 5002and both withdraw 5% annually. The first individual experiences gains in their early years, (say they retired in 1974, when the market was experiencing gains), while the other experiences losses in their early years, (say they retired in 1972, when the market was experiencing losses). The person retiring in 1972 would have run out of money in only 22 years (by 1994), while the person retiring in 1974 would still have almost $1,700,000 remaining in their portfolio after 31 years (2005)3. Thus, without doing anything different, the avoidance of losses in the early years was critical to the dramatically different results experienced by the two individuals.

The moral of the story? The next time someone tells you not to worry about short-term market volatility because your portfolio is designed for the long run, you might want to consider taking your money elsewhere. Remember, the #1 rule of investing is don’t lose money, because losses hurt more than gains help. And the most important factor for long-term success is short-term success.

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Boomers Resource Guide is a special supplement to the Senior Citizen's Guide