Sure, none of us want to lose money. That’s no fun! Making money and growing our investments is what we look to do. When you look at the math, its more important than we might think.
The world reknowned super investor Warren Buffet has even been paraphrased as indicating: Rule #1: Never Lose Money. Rule #2: Don’t forget Rule #1.
Sure, we have to take risks at times. It is a part of being an investor, and there is a risk/reward dimension that frames many of our choices with our finances. It even frames choices in our life too. But as a personal investor, its important to manage your portfolio with some simple math in mind.
And it really is quite simple, conceptually.
Here is a classic example:
Scenario 1: You have $100, but lose 10% in year one and gain 10% in year two. This means that after year one you have $90, and after year two you have $99.
Scenario 2: You have $100, but lose 20% in year one and gain 20% in year two. This means that after year one you have $80, and after year two you have $96.
Think about it.
When you look at both Scenario 1 and Scenario 2, its clear that once you lose money from a certain base amount, gaining the same percentage back on the new base won’t get you back to where you originally started. This is where losses in your portfolio – be it equity or real estate – can really wreak havoc with your overall financial situation. It might not be evident a the time, but it puts us behind the 8 ball, so to speak, when we lose money.
To further illustrate this, lets focus again on Scenario 2. With a 20% decline from $100, you’re then at $80. To get back to $100, you need to have a 25% increase in the following year. Again, showing that once you lose a certain percentage of money, you need to increase it at a higher percentage to get back to where you started. This can be a challenge; a 5 percentage point difference is fairly significant, all things considered.
An additional point to consider when looking at Scenario 1 and Scenario 2: look at where you end up in Scenario 2 vs. the first Scenario. In Scenario 2, since the percentages were higher, you end up at a lower amount after year 2. Thus, the bigger the loss, the harder it is to recover.
The takeaway from this as it applies to our investments is to carefully manage risks. Losing money puts you on a slippery slope when it comes to getting back to your starting point.
A further takeaway from this concept, taking it further, is that money can be hard to come by. Keep your earning power by having marketable skills, and live within your means by embracing sensible frugality. This puts you in a position to recover in other ways if your portfolio takes a hit.