Important investment Concepts, Part I
There are several important investment concepts that you should be aware of that will increase your chances of reaching your retirement planning goals. In this post I will discuss a concept that further illustrates why managing your investment risk is extremely important. This concept is “Big investment losses do more damage than big investment gains do good.”
If you have been saving a portion of your income every year from your first days of employment, you should have a significant retirement nest egg accumulated by the time you reach your early 50s. At this point in your investing life, with your retirement date now in site, it is very important to protect your retirement assets. Avoiding large losses should be objective #1 for all investors nearing retirement. The reason for this is simply the mathematics of investment losses versus investment gains. Please look closely at the adjacent table. I call this the “Breakeven” table.
The “Breakeven” Table
|
Percentage of Asset Loss |
Asset Return Required |
|
10% |
11.1% |
|
15% |
17.7% |
|
20% |
25.0% |
|
25% |
33.3% |
|
30% |
42.9% |
|
35% |
53.9% |
|
40% |
66.7% |
|
45% |
81.8% |
|
50% |
100% |
|
60% |
150% |
|
70% |
233.3% |
The table clearly illustrates that as the percentage of asset value loss incurred increases, the subsequent required percentage increase in asset value to get back to your breakeven point also increases, but at a much faster pace. The figures in the table are one reason why many people use “Stop-Losses” to protect the downside of their investments.
The 2008-2009 financial crisis provides an excellent real life example of the difficult mathematics illustrated in the table. In October 2007 the Dow Jones Industrial Average (DJIA) Index stood at about 14,100. At the crisis market bottom in March of 2009, the DJIA hit about 6,500. This drop in the index represented about a 54% loss of value. If you had a portfolio that was 100% tracking the DJIA index, even with the recent historic rise of the DJIA back to about 12,500 by the spring of 2011 (representing a 92% return in about 24 months), your portfolio would still not be back to breakeven from the 2007 market high. Your portfolio would have required about a 117% increase in value just to get back to a breakeven point from the 2009 market bottom.
People who did nothing during this period and continued adding to their retirement accounts likely have portfolio values that are very close to their pre-crisis values. If you fall into this category, I would consider yourself very fortunate for two reasons. First, because rapid market recoveries like this are rare, and, secondly, for not panicking during the crisis and making fatal investment changes as many people did.
The wild ride of the equity markets from late 2007 to early 2010 was very distressing. I am sure that most people, even if their financial assets survived intact, do not want to go through that experience again. Additionally, next time, it is unlikely that the equity markets will rebound so quickly. It is better to put yourself in a position to reduce the portfolio effects of any future large market swings to avoid as much as possible another traumatic experience again.
Let’s say you are 50 years old and have a simple portfolio constructed as 50% equities tracking the DJIA index and 50% fixed income. If you had a $500,000 portfolio value in October 2007, your portfolio value would have dropped to about $365,000 at the market bottom in March of 2009. This would represent a 27% drop in your portfolio value from the market top in 2007. Your portfolio would have required a 37% increase in value to get back to your breakeven point. I am sure, even with only a 50% equity allocation, that the wild market volatility would have still been very unsettling, but it is clear that needing a 37% asset return to reach breakeven is preferable to needing a 117% return to breakeven. And if you have the discipline to re-balance your assets periodically (read Post #15 for description of “re-balancing” process), the odds of your portfolio eventually recovering are much greater.
Remember when you are ten years or closer to your anticipated retirement date, it is important to avoid large investment losses. Since no one knows when these market downdrafts will occur, you should not try to predict sharp market drops. Use an appropriate equity allocation as described in Post #11 to Post #13 in this blog to control the size of your portfolio losses.
Did you enjoy this post? Why not leave a comment below and continue the conversation, or subscribe to my feed and get articles like this delivered automatically to your feed reader.
Comments
No comments yet.
Sorry, the comment form is closed at this time.