To Win? Or Not to Lose?
As humans, when it comes to investing, it is our default tendency to focus our efforts on the pursuit of large returns. We are more attracted to positions that have substantial growth potential, and we attempt to collect ‘winners’ one after the other, hoping that the combination of these positions moving in unison will result in an overall increase in our investment portfolios over time.
This strategy can work especially well during a prolonged upward-trending market, but as we all understand, markets are cyclical in nature and this strategy results in just as much momentum on the downside as it does on the up. This is all fine as long as we can tolerate the risk, right? As long as we don’t panic, markets trend up over time? Right?
Yes and No.
As savers and accumulators of wealth we have all learned about the importance of compounding, and the beneficial effect it has on wealth accumulation over time. Compounding results in geometric growth, as Ben Franklin once said “Money can beget money; and its offspring can beget more…”. The discussion of compounding usually takes place in the context of interest and positive returns. What about the effect of compounding in a world where returns fluctuate? Or can be negative?
This is where things can get ugly. The effects of negative compounding can be devastating and more impactful than their positive counterparts. For example – A $100 investment which loses 50% of its value requires a 100% return to break even. This means that the incurred loss causes the remaining funds to have to work twice as hard to regain lost ground. Negative returns can have a much greater effect on long-term investment performance than positive ones.
Take the example above; let’s say we invest in $100 in portfolio 1, at the end of year 1 our investment is worth $110. During year 2 our investment loses 10%, and at the end of the two years we are left with $99. In Portfolio 2, we invest the same $100, at the end of year 1 our investment is worth $150. During year 2 our investment loses 50%, and at the end of the two years we have $75. Both of these scenarios have an average annual return of 0%, but the end result is drastically different.
It is even possible to have a positive average annual return and a negative outcome. Consider the following scenario: Let’s take the same $100 portfolio we used above, only this time in year 1 we have a 50% return, followed by a -35% return. In year 1 our portfolio grows to $150, but in year two it falls to $97.50. The result of that period was a $2.50 loss, yet the average annual return was 7.5%. Consider that the next time you are evaluating the track record of a mutual fund.
So how does this affect our decision making when it comes to constructing investment portfolios? One of the best things you can do for the long-term growth within a diversified portfolio is reducing its volatility. Broad diversification and portfolio construction which takes advantage of non-correlating asset classes is a great start.
Using a broadly diversified selection of stocks across sectors, earnings multiples, and market capitalization, and taking advantage of different asset classes that move according to different market cycles, we have the ability to reduce the volatility within an investment portfolio. This strategy may not compete with the sometimes sky-high return of pure equity indexes, but will decrease the likelihood of geometric erosion and the detrimental effect of negative compounding.
One of our most difficult obstacles we face as investors is our inherent emotional nature. Greed and fear are hard-wired into our very being, and these are only two of the many traits that make humans terrible decision-makers when it comes to investing. We tend to chase after large returns, assuming additional risk at the wrong times, and we project infinite gains and losses depending on which way the wind is blowing.
If we can recognize these shortcomings; if we can recognize and control these default tendencies, we become better investors. In order to increase our probability for success and wealth accumulation over the long-term I argue that avoiding loss should be the priority, followed by the pursuit of stable consistent positive returns, not competing with an index or our neighbor for the biggest gains. For our Mariners fans; first do whatever you can to avoid striking out, then hit singles and doubles day after day.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.