Be a Math Teacher and Prepare Your Clients for Success

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One of the basic tenets of the financial markets that all investors need to embrace is the fact that gains and losses are asymmetrical.

Let me explain: An investor buys a stock for $100 and the stock drops to $50. The loss is 50%. For the stock to get back to even, from $50 back to $100, the stock will have to gain 100%. In other words, to recover from a 50% loss, a stock must make 100%. The gains and losses, expressed as percentages, are asymmetrical.

But the asymmetry gets worse as declines increase. For example, if a stock goes down 60%, then that stock must gain 150% to get back to even. A drop of 75% requires a gain of 300% to get back to even. A drop of 90% requires a gain of 900% to get back to even!

While the math is fairly straightforward, there is another aspect to this concept of asymmetry that can cause investors to wonder, “what happened?”

Let’s assume an investor places $500,000 in two strategies for five years: Strategy A and Strategy B. The returns look like this:

Year         Strategy A              Strategy B

1               -9%                            -3%

2               18%                          11%

3               -40%                         -9%

4               37%                          20%

5               29%                          16%

Both strategies have a simple average calendar year return of 7%.

But here’s where the differences in returns matter. At the end of five years, Strategy A’s value is $569,318, but Strategy B’s value is $681,939. Strategy B’s value is $112,621 more than Strategy A after five years!

This is an excellent example of the magnitude of the impact that the asymmetry of gains and losses has on long-term returns. You can see that Strategy A had some wild swings and much more volatility than Strategy B. Clearly, when the market was in an uptrend, Strategy B didn’t do as well as Strategy A. But the down-moves ultimately made the difference. Strategy B had limited losses, which positioned the investor to capitalize on the up-moves without having to realize huge gains just to get back to even.

This “market math,” as I like to call it, translates directly into real-life experiences that investors may have had. Consider the investor who was “smart” enough to invest on October 9, 2002, right at the bottom of the market after the “Tech Bubble” burst. The smart investor stayed invested as the market (S&P 500 price) gained over 101% into the market top on October 9, 2007. However, the investor then decided to “ride out” the 57% decline from October 9, 2007 to the market bottom on March 9, 2009.

Even though the investor had made 101% during the up-move and lost 57% during the down-move, the net result was a loss of 13.6% from October 9, 2002 through March 9, 2009, a period of almost seven years.

Since the year 1900, the Dow Jones Industrial Average has typically had 1.1 moderate corrections of 10% or more each year. Furthermore, there has typically been a bear market of 20% or more once every three years (Source: Ned Davis Research). Given these historical probabilities, it makes sense to ensure that risk management is a central part of your investment thesis.

The reason that investors need to recognize the importance of the market’s asymmetry is to make sure that they place the proper importance on risk management. Utilizing risk management techniques, such as diversification, hedging, utilizing cash as a defensive asset class and technical sell stops, will help to mitigate the large declines that can put an investor in a position of having to make even larger gains just to get back to even. While we all like to make big returns when the market goes up, it is even more important to avoid the big declines when the market inevitably goes down.

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