Portfolio Losses: The Mathematics of Recovery
Investing in financial markets always carries a certain level of risk, and even the most astute investors experience portfolio losses. When portfolio losses occur, a challenging reality sets in: recovering from these losses requires more significant gains than the initial losses themselves. In this article, we will delve into the concept of portfolio losses and the uphill battle investors face when attempting to regain lost ground.
Portfolio losses refer to the decline in the overall value of an investment portfolio, resulting from a combination of factors such as market downturns, poor investment decisions, or unforeseen events. These losses can be emotionally and financially distressing, as they erode the capital and potential returns an investor had accumulated over time.
The Drain of Losses
To illustrate this concept, let’s assume you invest $100,000 for 10 years. The markets over the 10-year period return a alternating periods of positive 10% and negative 10%. That is: Year 1 +10%, Year 2 – 10%, Year 3 +10%, Year 4 – 10%, etc. What is your return over the period?
The 10-year simple average of this sequence is 0% so intuitively you may want to say you $100,000 because the positive and negatives offset each other. However, the actual answer is that you would end up with a portfolio of only $95,099 by the end of the 10-year period or a total loss of 4.9%!
Looking at the first two years will help understand.
Year 1: You invest $100,000 and the portfolio grows by 10% or $10,000 so your portfolio is now $110,000. So far so good!
Year 2: Your $110,000 portfolio loses 10%. Except, your loss isn’t $10,000 which would get you back down to your original investment. A 10% loss on $110,000 is $11,000 so your new portfolio value is now $99,000.
Over 2 years, your average return is 0% but your portfolio is down 1%!
Over a 10-year period, this trend continues where each year of loss losses a little more than what the gains provide resulting in an overall portfolio loss of 4.9% by the end of 10-years.
How Does a Portfolio Recover?
In order to recover from a portfolio loss, your portfolio has to return a greater percentage than the loss that occurred. However, the challenging aspect of loss recovery is that the higher your loss, the higher the recovery needed to get back to even!
In the above case of the portfolio experiencing 10% down periods, the positive return needed to get back to $100,000 by the end of 10 years is 11.1% or 1.1% higher than your loss. That’s not too bad. But what if your loss is 20%? Now the return needed to get back to even is 25% or 5% more than your loss.
As the loss get bigger, the gain needed to recover and get back to even grows to where a 50% loss requires a 100% gain to recover!
The Takeaway
Recovering from portfolio losses is an uphill battle that demands a combination of financial acumen, strategic decision-making, and emotional resilience. The asymmetry of percentages means that regaining lost ground requires even greater gains, making the task all the more daunting. By understanding the mathematics of recovery, an investor can better understand the importance of implementing sound risk management practices, and maintaining a long-term perspective. While investing in a volatile stock market will always have a risk of loss, investors can improve their chances of recovering from losses and returning their portfolios to a path of growth and prosperity by maintaining diversified, risk appropriate, and goal appropriate portfolios.