The Math of Gains & Losses
Key Takeaways
The gains required to recover losses increases with deeper losses
On average, it takes 5 years to recover from a -40% loss
Returns have been positive despite deep losses, like a -50% drawdown
You can limit the probability of experiencing deep losses by considering risk first in your investments, avoiding over-concentration risk, and designing your portfolio for important goals in your life.
In The Sisyphean Road to Recovery, we highlighted the mathematics of loss recovery and how big gains must be made just to return your investment value back to par, especially once your losses cross a certain threshold.
Our core philosophy to managing money is to put risk first; by controlling your downside risk, you are able to capture more upside. Various measures of risk management is in place to mitigate deep losses such that your investments do not need herculean returns to go back to positive territory.
Using what we know about the recovery gains needed to recoup losses, we can then work out how much returns are needed on average per year to recover those losses. The diagram above works out how long you must wait, while generating returns on an average annualised basis, in order to make back your losses.
For example, after a -30% loss, you will need a cumulative return of 42.9% to recoup those losses. Given that a blended global index — representative of some of the core equity funds we use — generate long term returns of around 10%, you need around 4 years before you can break even. Going through a -50% loss means you need a 100% gain to recover — translating to a 10 year wait.
Immediately you would notice that, on average
The gains required to recover losses increases with deeper losses.
The deeper the loss, the longer it takes to recover. (Historically -20% losses recover in 2 years, -30% recover in 4 years and -40% losses recover in 5 years)
Returns have been positive despite deep losses (-50%) for all rolling 10 and 15 year periods.
How can you, as an investor limit the probability of experiencing deep losses?
Design your portfolio with risk in mind and avoid over-concentration risk, so that your investments does not experience catastrophic losses
Invest in the right assets; there is no surety of returns for assets such as single stocks or region-specific or concentrated “flavour of the month” investments.
Returns are only the tip of the iceberg. Designing your investments to meet the most important goals in your life, is what matters most.
In the same way that you would not attempt a high risk activity such as sky-diving without professional supervision, investors can benefit greatly by relying on an adviser — having the peace of mind knowing that their plan is in the hands of a professional.
If any of the points speak to you and you would like to have a exploratory discussion, click here to schedule a chat with us. (Our 30-minute exploratory meeting is complimentary - either Zoom or In-Person)