To Win? Or Not to Lose?
When it comes to investing, our default and very human tendency is to focus on the pursuit of large returns. We’re attracted to positions that have substantial growth potential, and we attempt to collect ‘winners,’ one after the other, hoping that the cumulative movement of these positions will result in an overall increase in our portfolios over time.
This strategy can work especially well during a prolonged upward-trending market, but markets are cyclical in nature. For as much momentum as there is on the upswing, the same goes on the downswing.
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.
Compounding is for better and also for worse.
As savers and accumulators of wealth, we’ve all learned about the importance of compounding and its beneficial effects, especially in the context of interest and positive returns in the long term. As Ben Franklin once said, “Money can beget money; and its offspring can beget more…” Sure, when compounding is working in the way we like it to, as in geometric growth. But what about the effect of compounding in a world where returns fluctuate, or can even be negative?
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. With this loss, the remaining funds now have to work twice as hard to regain the investment’s original value.
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 $100 in Portfolio 1, and at the end of Year 1, our investment is worth $110. During Year 2, our investment loses 10%. At the end of 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%. 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’s even possible to have a positive average annual return and a negative outcome.
Using the same example—
Let’s take the $100 portfolio we used above, only this time, in Year 1, we have a 50% return in which it grows to $150, followed by a -35% return in Year 2, in which 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 inform how we construct investment portfolios?
One of the best things you can do to encourage long-term growth within a diversified portfolio is to reduce its volatility. Aim for a broadly diversified selection of stocks across sectors, earnings multiples, market capitalization, and asset classes that move according to different market cycles. This strategy may not compete with the sometimes sky-high return of pure equity indexes, but it will decrease the likelihood of geometric erosion and the detrimental effect of negative compounding.
As investors, one of our most difficult obstacles is our inherent emotional nature.
Greed and fear are hardwired into our very being, and these are only two of the many traits that cloud our ability to make rational decisions in investing. We tend to chase after large returns, assuming additional risk at the wrong times, and project infinite gains and losses depending on which way the wind is blowing.
If we can see our shortcomings, if we can recognize and control our default tendencies, we become better investors. To increase our probability for success over the long-term, rather than competing with an index or our neighbor for the biggest gains, we need to make avoiding loss our priority, followed by the pursuit of stable, consistent positive returns.
In other words (for our Mariners fans), first do whatever you can to avoid striking out, then hit singles and doubles, day after day.
This 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.
