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Understanding Losses In Your Portfolio

by My Journey to Millions

I don’t think most individuals really understand what happens when their investments take a hit and lose value.  I was reading a great article about using protective puts and covered calls with index funds to provide for hedging and while the article was very interesting (and something I am going to look into and write about this week) there is such a simple concept found within the article that is often lost on investors.  It is the concept that when you lose X% in your portfolio you are going to need X% + Y to get even.

Getting Your Investment Portfolio back to Even After Unrealized Losses

We will take an easy example found in the article,

Many clients who lose 25% one year and gain 25% the next assume they are back to even. But under this scenario, a $100,000 portfolio becomes $75,000 and only recovers to $93,750. Larger losses make things worse: A 50% loss requires a 100% gain to get back to even.

It always amazes me when I read stories of near-retirees being 70%, 80% or even 100% in equities, or almost worse, when they don’t know exactly how much risk they are taking!

The article even provides a fantastic graph showing exactly how much you need to gain after losing X% (mentions the Source as: Kingsroad Financial Insurance Services, Inc.).

As the graph indicates the larger the loss the harder it is going to be recoup your losses.

This is one of the reasons I never understood when people brag that they have all their funds in an S&P index fund.  If you were unlucky enough to retire in one of those years when the market was down 5 to 20% AND you took a withdrawal it is going to be really difficult to get back to even.

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Ravi Gupta 04/25/2011 - 9:36 am

Great article! You’re absolutely right that you need to gain more in order to offset the income that you lost. It makes me question why more people don’t diversify more as to hedge against a single point of failure.

-Ravi Gupta

Evan 04/26/2011 - 8:16 am

That’s why I don’t particularly understand why there are bloggers who brag that they are in just 1 index fund…

Dave 04/25/2011 - 12:31 pm

I am amazed at how many people don’t understand this concept! I have talked to so many people that think if you lose 10% one year and gain 10% the next year you are back to even! It just seems like such a basic math concept to me that everyone should understand this.

Evan 04/26/2011 - 8:17 am

I don’t judge people when they don’t understand concepts like this – it bothers me more when people don’t understand that if they spend more then they earn they’ll just be floating along lol

101 Centavos 04/25/2011 - 5:31 pm

Right you are, Evan. This concept is not front and center into most frontal lobes. I’ve heard comments along the lines “Yeah, we’ve made back what we lost, and more besides”, to be followed by befuddled looks when I ask if that includes contributions and company match.

Evan 04/26/2011 - 8:29 am

I am so guilty of ignoring the contributions on my 401(k) when looking where I have been and where I am going lol

JT McGee 04/25/2011 - 6:46 pm

I don’t think it makes all that much sense to pile into fixed-income right now; you’d be buying in at a historic top.

Should you be in 100% equities with retirement approaching? No. But should you be in fixed-income ahead of rising rates? Only if you buy the short-end of the curve, and it isn’t paying anything.

Thinking in terms of stocks vs bonds doesn’t make all that much sense, you’re not necessarily safer because you own fixed income. I would definitely be a proponent of taking on put options in this low-beta climate, but I won’t be buying fixed-income directly–it just doesn’t make sense, IMO.

Evan 04/26/2011 - 9:13 am

Options – covered calls and protective puts are a fantastic strategy. So is a simple SPIA or similar annuity…transfer your risk to an insurance company.

krantcents 04/25/2011 - 6:55 pm

Good reminder! This market is so volatile that I am up for a few days and down for a couple. Over all I am up, I feel I am on a roller coaster.

Evan 04/26/2011 - 9:51 am

Why not use out of the money options as another stream of income?

Funny about Money 04/26/2011 - 12:08 am

Good article.

So as the person approaches retirement, what proportion would you like to see in equities and what in less risk-prone instruments?

I’ve been told the percentage in bonds & FDIC-insured accounts should = your age. That is, if you’re 60, only 40% of your holdings should be in equities and 60% should be in more conservative holdings. By age 70, the balance would shift to 30% equities and 70% stodgier stuff, and so on.

Problem is, one wonders if this distribution would allow you to keep up with inflation, especially if you lived much past about 80.

Evan 04/26/2011 - 9:53 am

I think I can only answer that question with more questions….
– Risk tolerance of the person?
– Any other sources of income (pension, annuity, etc.)?
– Spending habits of the person?

I think it is much more complicated than the Suze Orman/Dave Ramsey type of one-fits all advice.

Funny about Money 04/26/2011 - 10:04 am

LOL! Risk tolerance seems to vary with the state of the market. When things are trending upward, one throws caution to the wind. A downturn brings on a sudden attack of risk sensitivity.

Over time, 401(k)’s and 403(b)’s seem to have replaced pensions, although certainly a number of boomers are still enrolled in pension plans. I’d guess that a large percentage of younger investors will have no second source of income except Social Security — assuming SS exists at all by the time people now in their 20s, 30s, and 40s reach their dotage.

Evan 04/30/2011 - 2:17 pm

That is why a good advisor is a great tool to have you in your corner. To remind you that when things are great they could be worse and when things suck to talk you off the ledge

Barb Friedberg 04/26/2011 - 7:59 am

Evan, I’m pleased you wrote about this topic. It’s not widely discussed and is a reason to focus on capital preservation in addition to growth!

Evan 04/30/2011 - 2:25 pm

I don’t think most people even worry about capital preservation…


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