When it comes to investing, it’s easier to fall into the hole than to dig your way out. That’s because when you lose money you have a smaller principal. The math of percentages is a harsh mistress that demands a toll for every loss. That toll is called the Math of Loss and the price it demands is that future returns have to be higher than the original loss to get back even. Yes, you read that right. If your 401(k) plan loses ten percent, a ten percent gain does not make you even again.
How long it takes any single investor to recover from a loss will vary depending on your investing style and asset mix. Everyone has heard that it took the stock market twenty-five years to recover from the crash of 1929. While it may be true that, if you had bought at the market peak, bought only stocks that lost the market average and didn’t put any additional money in the market, then it might have taken a quarter century to recover. Fortunately, that’s not a smart way to invest and you shouldn’t do that. Still, it’s a lesson about loss that resonates down to our financial world today. Learn from that history.
The Wealthy Buy Protection from Loss
Interestingly, large investors understand the math of loss very well and know that the way to stay ahead is to sell stocks at the first sign of a down market. They don’t call their broker to execute the trades. They have high speed computers watching their portfolios. At the first sign of selling, these high speed trading systems sell off stocks. If conditions look better they buy back in just as quickly. These high speed systems execute trades hundreds of times a second, all to protect large investors from steep losses. Of course, all that computerized high-speed trading tends to make markets crash very quickly. Do you have rooms full of sophisticated computers guarding your retirement fund? No? Then take a guess who gets stuck with the losses.
Steep Loses, Slow Recoveries
Market losses tend to strike like lightning, racking up steep losses very quickly. It then takes years for market indexes to recover and even longer for investment funds and 401(k) accounts because fund managers go right on collecting fees even when markets go down. Nice work when you can get it. The tough bit about loss percentages for small investors is that steep losses are geometric. With a ten percent loss it takes an eleven percent gain to get back even. If losses extend to twenty-five percent, it takes a thirty-three percent gain just to get back even. As we can see on any week watching the stock market, the climb out of that pit won’t be smooth or steady. There will be periodic down days that set your recovery back with a never ending series of razor cuts.
You Have No Protection
While the super-wealthy and big investors have high speed computers limiting their losses, you don’t. Too many people are just stuffing money in a 401(k) and not thinking about protecting themselves from sudden loss and people in their forties and fifties don’t have twenty years to earn back losses. That means shifting money out of stocks into cash, bonds and liquid hard assets as you get older. It also means changing your stock mix to focus on dividends and trend away from growth funds as you get closer to retirement.
For older Americans there is absolutely no incentive to risk your retirement fund in the stock market. It’s okay to transition into a saver as retirement approaches and shift your focus to hard assets and preserving your wealth. Your fund manager is going to get paid even if you lose money, so you can’t count on them.