This simple piece of advice is rarely discussed, but always learned. Unfortunately, it is often learned the hard way. Building long-term wealth is not about how much you gain, but how little you lose.
This is because when it comes to compounding returns, gains and losses of equal size are not equal at all. It is a concept that is so simple, yet nearly universally overlooked by individual investors.
Let’s take a look at a very simple example. Let’s say you start with a $100 investment, and the first year you see a 50% gain. The following year is not so good and you suffer a 50% decline on your investment. Most people think you’re back to where you started, but you are not… you’re at $75. If you suffer a really big loss, say 90%, it requires 900% in future gains just to get back to even. This is because losses have a bigger impact on your money than gains.
During my 10 years in management at Morgan Stanley, our most successful clients were not the ones that swung for the fences trying to hit home runs. Those who did, inevitably struck out at times and fell victim to math discussed above. No, our most successful clients were the ones who consistently achieved high single-digit returns over the long-run (10–20 years).
So How Do You Avoid Those Big Losses?
You have probably heard the phrase, “don’t put all your eggs in one basket”. This is Diversification 101. The idea is to own a combination of assets that tend to move in opposite directions of each other. Stocks and bonds are the most common form of diversification. In general, when stocks prices fall, bond prices rise. By having a balance of stocks and bonds, you can begin to reduce the fluctuations you see in your investment portfolio. This is a tried and true method of keeping your losses small.
You should also avoid the urge to try and pick stocks yourself. There are a number of new apps that make it easy to buy stocks with just a tap of your finger. Heck, the service is free (unless you read the fine print). Is this a good thing?
Most people think that professional money managers, those people who pick stocks for a living, tend to outperform the stock market. This unfortunately, isn’t true. In fact over that last 5 years, roughly 85% of mutual funds, those managed by seasoned investing professionals, can’t beat the market (see for yourself). If you look at a longer time period, the story doesn’t improve much at all. Over the last 15 years, only 17% of professional money managers beat their benchmark, while 83% underperformed. If this group can’t beat the stock market, what do you think your chances are? And no, that slick new app with the cool stock chart isn’t going to tilt the odds in your favor.
This fact, is why many investors have opted to invest in low-cost exchange traded funds that simply track the performance of the stock market. By owning an index fund, you are essentially buying a tiny sliver of every stock in the index (diversification). Rather than buying one stock, you spread your risk across many, often hundreds, of stocks.
What About Events Like 2008?
Unfortunately, there are times when financial markets go hay-wire. Fortunately, these periods are few and far between. When they do happen, it’s typically because the economy falls into a recession. In fact, eight out of the last ten bear markets (20% or more decline in the stock market), occurred during recessions. It has now been nine years since the last recession. This is the second longest stretch between recessions in history. The notion that the stock market can produce huge losses is beginning to fade from the average investor’s psyche.
In the aftermath of the 2008 Financial Crisis, I decided to do research on what causes recessions. Admittedly, it was out of self-preservation that I did the research. I had been working for a large bank during the crisis and I certainly didn’t want to get blindsided again.
After years of research and testing, I developed our Business Cycle Indicator that uses a combination of economic data to forecast recessions. This research was developed in 2014, using economic data that goes back to 1968. During that time the US Economy suffered seven recessions. Our Business Cycle Indicator would have successfully predicted all seven of those recessions. On average the warning it provides came 13 months before a recession began.
This research process is the cornerstone of our CycleWise Portfolios that are designed to provide upside when the economy is expanding, but more importantly, protection from recessions. Remember, keep your losses small.
Unfortunately, recessions are a natural part of our economy, and the next one is coming. It will be painful, and it will likely result in millions of investors collectively losing trillions of dollars of their hard earned capital; just like every recession before.
At Prepared Capital, our mission is to make sure that it is not your capital.
This post is an expansion on my answer the question: “What is the best stock market advice you ever received” on Quora.