Why it is better to lose small than win big
Imagine this: the year is 2014 and your diversified investment portfolio is earning a measly 7% while your neighbor Joe’s S&P 500 index is up over 14%(1). As if that wasn’t enough, Dianne, across the street made a risky decision to buy airline stocks and she’s all but doubled her investment (2)! So what gives? You’ve hired a financial advisor, and they don’t seem to be keeping up. This is the plight of many investors, but when is the last time Joe and Dianne came to your door to tell you about their big loss?
Oftentimes investors let emotion guide investment decisions. When others seem to be winning, it’s only natural to want the same, but while our peers love to brag about “beating the market” short term, they rarely, if ever, admit when they make the wrong decisions. Concentrated investing means big risk, and yes it is true that big risk can mean big returns, but it also puts a lot of unnecessary stress on your investment dollars. Consider the charts below that navigate through 2020’s ‘Coronavirus Crash’.
This first chart shows the market at its high on February 19, 2020 down through the low on March 23rd and back up to the recovery on August 18, 2020. In this amount of time, the S&P 500 had gone from 3,386 down to 2,237 and back up to 3,390 - a net rate of return of 0.11%
Now, let's focus on the high to the low. In just over a month, the S&P 500 had lost 33.92%. Let’s say you had started with a $100 investment on February 19. By March that would have been down to $66.08. So the question is: how hard does the remaining sixty-six dollars have to work in order to gain your money back?
If you said “over 51%” you would be right. Now, because of the big loss, your dollars have to work MUCH harder to get back to their starting point. Luckily the S&P 500 had done just this, and by August 18 had returned 51.51% as outlined in the chart below.
Let’s consider an alternative set of circumstances. What if instead of investing in just the S&P 500 you had bought a blend of different types of stocks and maybe even some bonds? Let’s say, hypothetically, you had only lost half of what the S&P 500 did over this time period and your $100 investment only went down by 17% to $83. Now you only need to return around 20.5% to get back to where you started. Notice that it takes less than half the growth to recover from half the loss. In fact, if the investment that lost by half also grew by half, you would actually end up with $104.38! So the next time it seems like your day-trading neighbor has all the answers, take some time to review your financial goals, review your financial advisor’s investment philosophy with them, and remember that it is better to lose small than it is to win big.
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Written by Justin Meyer