Message from the Market

 

Issue #2: Mathematics of Losses

“the market has a message for those who are listening”

By:  Christopher Wills CPA, CFA, CFP

In this post I will discuss the “Mathematics of Losses” to help you understand why limiting portfolio losses is so important. The key takeaway is the investment return/gain needed to fully recover from portfolio losses grows exponentially with the size of the loss. The chart above illustrates this point.

Let’s say you have a starting portfolio value of $100,000.

And assume your portfolio value decreases to $80,000. This represents a loss of $20,000 or 20%.

What rate of return is needed to get your portfolio back to the $100,000?

The answer is… 25%.

That is 5 percentage points higher than the 20% loss you incurred. As the loss gets larger, the rate of return needed to breakeven grows exponentially.

As illustrated in the chart above, a 30% loss requires a 43% gain, a 40% loss requires a 67% gain, and a 50% loss requires a 100% investment gain to breakeven!

Let’s use market history to demonstrate a real-life example of what investors experienced…

From the market peak in October 2007 to the low in March 2009, the S&P500 declined 58%. If your portfolio of $100,000 was fully invested in the S&P500 index, the portfolio would have lost $57,693 resulting in total ending balance of $42,307. From this point you would need an accumulated portfolio return of 136% to breakeven at your $100,000 starting value!

This ended up taking investors over four years, reaching a breakeven around April of 2013 (excluding interest & dividends) and assuming you didn’t panic sell during the volatile market declines. For the average investor, without an advisor, breakeven took about 6 years and some still have not fully recovered.

At Aventine Financial our goal is to avoid part of the bear market decline by significantly reducing equity exposure (stocks) and then returning to a more “normal” asset allocation once our market indicators (combination of both fundamental and technical) gives us a “buy” or green signal.

As your financial coach, we see two major advantages to this strategy versus a typical buy and hold investment approach:

  1. It helps you “sleep better” during the worst of the decline knowing that your investment portfolio or retirement “nest egg” is positioned more conservatively.
  2. It protects your investment gains generated during the market uptrend which should improve long-term performance due to the Mathematics of Losses.

It is this Investment Philosophy that is central to the risk management process we use at Aventine Financial Group.

While market indicators are critical to our disciplined investment process, there is still an element of professional judgement involved and why our process is not for the “do it yourself” average investor.

The best way to benefit from our knowledge and experience is to join our family at Aventine Financial.

Until next time…

All the best! – Chris

 

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