Win by Not Losing
Investment style means something different to everyone. For some, the thrill of the “game”, with the occasional big gain and story are the driving forces. Others are petrified to look at the news for fear of seeing a loss in markets. There are few other areas of life that draw out the emotional extremes as much as a person’s finances and investment situation. While some might think that folks with great stories about their latest win in crypto currencies or huge returns a penny stock must have it all figured out, over the long term, that often doesn’t prove correct.
First, the math. The size and sequence of returns matters for investors. The larger the loss, the higher the return must be to get back to the starting point. You might say “no kidding”, but take note of the difference in returns necessary to recover from a loss:
Avoiding large losses can make a big difference because it doesn’t take nearly as much price recovery to get back to the value prior to the loss. This is meaningful but becomes critical during some parts of an Investor’s financial lifecycle.
Most people experience a few broad phases in their investment life, and each can create a unique objective relative to risk & return priorities. Investors who are at least 5 years away from retirement are in an “Accumulation” phase where the primary objective should be saving and building wealth. Leading up to retirement, Investors are in more of a “Transition” phase to support decisions about their upcoming retirement. And during retirement, Investors are in a “Distribution” phase where hopefully, they can reap the benefits of their hard work over the years.
Avoiding large losses is most critical during an Investor’s Distribution phase, because the impact of taking cash out of a portfolio while prices are low can be devastating. In addition, the timing of the loss makes a significant difference. In both examples below, an Investor starts with a $1,000 portfolio and takes a $50 distribution each year. Over a 10-year period, each Investor also experiences one year of a 25% loss and enjoys an average annual return of 7.3%. However, the Investor in Scenario 1 benefits from good years early in the cycle and the Investor in Scenario 2 faces the market loss right away.
Despite the similarities in distribution, maximum loss and average return, after 10 years, the first Investor has a balance of $1,207 and the second Investor has $939 – more than 22% less! Over a long retirement that many Investors hope to enjoy, it is vital to most people to avoid taking large losses, especially early in retirement.
Even in the transition years leading up to retirement, taking large losses typically creates a tremendous amount of stress that reduces financial flexibility during retirement. In some cases, large losses can even delay retirement while Investors work to rebuild balances to meet their financial objectives.
It is only during the accumulation phase that Investors are generally rewarded for taking more risk. The best long-term wealth outcomes generally come down to 2 factors: savings and investment for growth. Accepting more market risk to create an opportunity for higher growth is often a favorable approach during this phase. Even during a bout of market volatility and losses, if the Investor continues to save and makes regular investments in growth assets, they will eventually be rewarded with higher growth as those assets recover in price.
So, while there is a time for Investors to go after returns, it is the consistent saver and investor who often enjoys the most financial flexibility during retirement. Freestate Advisors supports clients with financial planning and regular reviews to try to improve that consistency and optimize an investment strategy based on each client’s objectives. Further, we have significant experience in managing investments to win in the long term – by not losing at the wrong time.