FEATURE
Grow Your Money.
The Importance of Not Losing Money in your Portfolio over Extended Periods of Time By Edward Brown, Pacific Private Money
W
arren Buffett said, “Rule #1: Don’t lose money. Rule #2: Refer to Rule #1.”
Einstein famously quoted, “Compounded interest is the eighth wonder of the world.” However, what is not included in this quote is how it is important to avoid loses, for compounding is a double edge sword. The power of compounding only works when you do not lose money. This is also true when considering dollar cost averaging. If there is a continual downward market, dollar cost averaging only means that you will have more and more shares that lose value [as you purchase more shares when the price is lower than before]. Losses that compound are even more devastating than compounding interest [or gains]. For example; if one were to invest $100,000 and lose 20% the first year, the ending balance of the account would be $80,000. The following year’s return would have to be an increase of 25% [$80,000 X 25% = $20,000] just to break even. This does not include making a profit over the two year period; it just means that, over a two year period, the return would be zero.
14 Originate Report | April 2019
If the same $100,000 earned 20% per year compounded for three consecutive years and then suffered a 20% loss, the annualized compounded rate of return would be less than 8.5% rather than 10% [3 years X 20% = 60%, less 20% = 40% / 4 years =10%];
Here is how the figures work:
Original investment $100,000 Year 1 20% increase: $120,000 [Value at the end of year 1] Year 2 20% increase $144,000 [Value at the end of year 2] Year 3 20% increase $172,800 [Value at the end of year 3] Year 4 20% decrease $138,240 [Value at the end of year 4] The time value of money shows that a $100,000 investment turning into $138,240 in four years equates to compounded rate of return of less than 8.5%. Thus, the effect of losing money, even after gaining three years in a row [in our example] is worse than a steady increase. If, in the above example, the investment simply increased 10% compounded per year, after
four years, the account would have grown to $146,410. The difference of $8,170 [more than 2% per year on average] represents the severe hit the investment takes when there is a loss of any real magnitude; thus, the importance of a steady positive return per year versus the ups and downs that an investment may experience over time. The main reason for the powerful downside impact of losing money is that, if the loss happens before any gains [early in the investment years], there is less principal to work with to achieve a significant increase. If the losses happen after significant gains, then there is a fairly sizeable loss of investment as seen in the above example between years 3 and 4. The larger the swings in increases and decreases, the more significant the difference in risk adjusted rates of return. The example above showed 20% increases for three years and then a 20% decrease. The difference in a fluctuating return [of both positive and negative years] reduced the return of a potentially steady rate of 10% down to less than 8.5%; however, what if the first three Grow Your Money: continues on pg. 16
