The downside of an investment can cause significant loss of capital. Without appropriate action this loss will reach a point where an investor will not be able to recover capital. In addition to this, the upside of investing, gains obtained on assets can quickly disappear with market decline in a disproportionate fashion as illustrated in this graph.
To understand this more clearly, we will use a few examples, building on our $1 Million windfall discussed here.
$1M Starting Value For Investment
A market correction hits, creating a 10% decline in overall markets, you panic and sell.
$900K capital value after taking a 10% loss
To recover your $100K loss, using this graph, we can see we will need to realize an 11% gain to bring our now $900K in capital back up to $1M.
Let Us Assume We Were Able To Recover
And we now, again, have $1M in capital to work with.
We are now hit with a bear market which causes a 30% decline in the value of our portfolio. You panic and sell, realizing the loss. You now have $700K in capital to work with.
Again, using our graph, we now must find investment selections which will produce a 43% gain for us to recover our loss in capital and reach $1M in capital once again.
As Losses Increase
As losses increase, the gains required to recover from this loss increases in a non-linear fashion. The higher the loss, the lower the likelihood you will recover your initial investment. If you invest your full $1M in one company and that company goes to zero, your 100% loss brings your capital to $0. There is no recovery in this case, anything multiplied by zero always equals zero.
An initial investment in a very exciting IPO that goes to zero, creating a 100% loss, gives you the opportunity to learn from your mistake and start over.
On the upside of investments, let us say we had a great year and we bought when markets were just coming out of a decline. We just happened to buy in with our $1M in capital as markets turned positive across the board. By the end of the year our portfolio earns a 30% increase and portfolio value is now $1.3M. You are extremely happy about this and see only golden opportunities in the year ahead, you post repeatedly on social media how you mastered the investment markets and produced 30% gains.
Financial Analysis, Who Does That?!
Unfortunately, you missed a few macroeconomic elements lurking beneath the surface, heading into the new year the market takes a quick correction, showing a 13% loss. You feel confident, smart money says this investment can only go up, you hold. The markets turn bearish and your portfolio takes another 10% hit. You panic and sell.
You now have $1M in capital.
How did that work, your 30% gain gone, with a 23% decline in markets?
The non-linear relationship in gain/loss is unfairly tilted toward more significant impact from loss.
Which is why many investors investment policy includes this overarching principle: Avoid the loss of capital.
You are a genius investor and your $1M portfolio sees 100% gains, creating a $2M portfolio, a 50% loss will put you back where you started.
Mathematics is the supreme judge; from its decisions there is no appeal.
Tobias Dantzig
This non-linear relationship in failure and success can be transferred metaphorically to life. When things are progressing well in life with relationships and career success these positive gains can create compounding growth for you and within you as an individual. Difficult circumstances, poor decisions and bad habits can put you in a rut that you may not get yourself out of without essentially starting over.
The Investment Journey Is More Difficult Once You Stop Growing
Become expert in operating in your sweet spot where you see more gain than loss, where you are disciplined in your approach and learn quickly from mistakes. More growth than decline, more learning than yearning.
How do you do this in life? Stick to what you are good at, bring the best of yourself out every day and focus on your vision. With money, avoid these great destroyers of wealth.
And
Be aware of the mathematical reward/risk relationship in the background of your finances.
Keep things simple and don not swing for the fences. When promised quick profits, respond with a quick, no.
Warren Buffet
Why do you need to be aware of this in your journey to build wealth? Market decline and Bear markets occur frequently as illustrated in the following tables.
Additionally all of our posts in the Passive Income series can be found here.
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