Managing Financial Risks: The Tricky Math Behind Losing Money

When we think of ways to build wealth, we often think of ways to make more money and spend less money. The more you make, and the less you spend, the more you keep.

Over time, that can accumulate into a solid foundation for retirement, and help us to grow net worth.  However, we must also watch out for some financial pitfalls along the way, though proper risk management.  One very basic way to do this is to simply avoid losing money.   It’s basic, yet interesting how the math works: you get excessively punished over the long run when you lose money on an investment or other financial decision.

Here’s what I mean:

Let’s say you start with an investment of $10,000 in a company’s stock. Let’s say that company has some negative developments, and its future looks less rosy by the end of that year. Further, let’s assume that the stock drops 20%.  This means that your $10,000 investment just fell to a value of $8,000.

Okay fine, not the end of the world, right? As we know, the stock market can be volatile, so if it goes down one year it might go up the next, right?  Let’s say it goes back up 20% the following year.  Does that cancel out the 20% loss from the prior year, to make us even?

No.  A 20% increase from $8,000 puts us at $9,600.  To get back to where we started, $10,000, the stock has to go up 25% in that second year.

If you lose money, it takes a larger percentage increase to catch up.  Lose 20%, and you have to gain 25% to break even.

I think this basic concept speaks to the importance of managing financial risks, and making sure to avoid big financial losses.

Keep in mind that I’m not saying that one shouldn’t invest in the stock market. I’m simply using the stock example to illustrate how any investment or decision resulting in a loss can make our money have to work harder to get back to break even.

How can we avoid big losses while managing risks? Here are a few examples:

  1. Buy index funds.  You’re still buying stocks, but you’re diversifying risk compared to focusing on just one or a few stocks.
  2. Get the right insurance.  Home, car, and other insurance policies can help protect us in the event of disasters.  Problems can and do happen, even if some are less likely than others.
  3. Conduct good estate planning.  In the event of an unfortunate passing, nobody wants their money to be given to somebody not deserving! Also, nobody wants to see fighting over an inheritance divided between siblings.  While this is a different type of loss, its one most would want to avoid.
  4. Do your homework.  By this, I mean actually think about big purchases analytically and not just emotionally.  For example, buying a home that is a good value versus buying a dream home based on emotion and not much else.
  5. Watch out for scams.  There are scams that happen all over the place, and it’s particularly tragic when it happens to unknowing seniors. Even those of us that aren’t of that age often face jokers who try to swindle us.  Have you ever received one of those emails promising a financial windfall?

Bottom line is that once we lose money, it’s harder to get it back based on the math.  Risks are a normal part of life and investing, but we should be sure to remember the downside and protect against it.  We just might end up very thankful we did!

My Questions for You:

Do you ever think about how a certain percentage loss requires an even greater percentage gain just to get back to where you started?

Do you manage risks based on the 5 ways listed?

Are there any other suggestions you have for managing financial risks?

Comments

  1. says

    I think your list of how to manage risks is a good one. This probably falls under your #5, Watch Out for Scams, but I think we really have to be wary these days of identity theft and malware that can REALLY mess up our lives for a while. I try to follow-up on all the recommended preventatives, but still I worry. It seems the crooks are always one or two steps ahead of the good guys, and very, very clever!

    • Squirrelers says

      Wayne – thanks, I wanted to write about avoiding losing money because I think it’s a topic that’s not written about enough. Articles on saving money could be viewed in this light, but that’s a bit different.

    • Squirrelers says

      Jai – yes, they minimize risk but still have some attached. I agree. But that’s better than pouring it all into one stock!

  2. says

    Sometimes I forget that you need to make more back if you lose as a % but the dollar amount is still the same – 2k in the hole is 2k, no matter the percentage. To diversify, I usually use index fund and am properly insured, but hopefully will continue to expand these as I get older.

    • Squirrelers says

      Jeff – it’s good to think of the math, and agree that as we get older we probably need to expand on this line of thinking regarding minimzing losses.

  3. says

    I have thought about how much harder it is to make money back after a loss. I usually manage risk through diversification…diversified investments and diversified income streams. It helps me feel better and usually helps minimize loss.

  4. says

    I manage risks by diversifying. In my retirement accounts, I am 100% invested in a mix of funds. In my stock account, I diversify by buying a mix of companies that have solid histories and bright futures.

    • Squirrelers says

      Eric -diversification can be a good thing, and often a nice way to minimize the risk of excessive losses.

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