Let’s take a quick quiz:
What is the most important action you can take to make more money from your investments and protect your investments in retirement?
While D is the right answer to many questions, in this case, C is correct. The key to making the most money over time is to lose as little of it as possible. Before we discuss how to limit your losses, let me prove my thesis.
If you lose 10% on an investment and later the investment increases 10%, are you back to even? It seems reasonable that the answer would be yes, but let’s do the math to be sure:
So, when you lose a certain percentage on your investments followed by a gain of the same percentage, your investments are worth less than when you started. It turns out that in order to break even after a 10% loss, you have to earn 11.1111%.
You might be thinking that having to earn 11.1% to break even after a 10% loss is no big deal, but it gets worse:
The more you lose on an investment, the more you have to earn in the future to either break even or get ahead. On the other hand, if your losses are limited, your investment account can increase faster. Here is an example:
Over the past 45 years, the S&P 500 has only had nine negative years. Because of the power of compounding, a $1,000 investment on January 1, 1970 would have grown to approximately $96,000 on December 31, 2014 absent taxes. If you had reduced the losses in the down years by only 30%, your $1,000 investment would have been worth approximately $160,000. That’s a 67% increase in total account value by reducing losses in only nine years by a small amount.
How common are losses in the stock market? For the last 45 years, the S&P 500 has lost more than 15% of its value on 14 occasions. On average, every 3.2 years, the market loses more than 15%. Here is a list of the losses with the five worst losses highlighted:
The last time the market had a 15% or more loss was in 2011, more than three years ago. It is quite possible that we will see a large loss in 2015. Will you be ready?
Part 2 – How to limit Your Losses is coming soon.