The Big Loss is the ultimate game changer in personal finance. As big and painful as the Big Loss is, it takes an even bigger gain to get back on track plus the pain of the draw-down experience spawns the worst of investment decision making.
Losing 20% or more of your life savings is painful. It takes years of hard work and discipline to save up that money and then poof, tens or hundreds of thousands of dollars evaporate into thin air. Ouch.
As much as that hurts, getting it back takes even more hard work and discipline. In order to recover from a 20% loss, you have to make back 25%, just to get to even. A 33% draw-down requires a 50% followup gain and should the market eat up half of your money (as it did in the Great Recession of 2007-09), the remaining balance has to double (grow 100%),
Compounding the problem, all that effort is only enough to get back to where you were before the Big Loss occurred. In the meantime, you expect to make money each year and that adds to the size of the gains that are required in order to really feel like you’re back on track. For example, if you lost 20% in year one and took two more years to get it all back including your expected gains, you’d have to get a 21% return during EACH of those two recovery years – not impossible but certainly not easy – which requires taking on more risk than you’d probably like and stomaching even more volatility.
All this takes place at a time when you’re emotionally scarred, hyper-sensitive to risk and most likely to want to pack it all in and sell everything. The human brain is wired to make poor investment decisions at precisely the worst times – to buy high and sell low (exactly the opposite of what makes money).
Traditional investment advice is to suck it up and stay invested. “You’re in it for the long haul,” you’ll hear from your advisor and they are technically correct for saying it … but … you’re human and the odds are you won’t listen.
There are two ways to address this challenge: Ignore human behavior, invest the portfolio following traditional buy-and-hold methodology and force yourself to stay invested after losing as much as half of your money … or … avoid the Big Loss altogether.
I’ve lived through the traditional approach. In 2009 I got to tell my clients that we beat the market by 20% or more and “by the way, you still lost a quarter of your money!” Some clients stuck with their investment policy and they have since recovered. A few fired me right away and a whole bunch were miserable for a year or two until they eventually left.
Avoiding the Big Loss isn’t all that difficult. Designing a fully-diversified (not just U.S. stocks and bonds) portfolio that meets your risk parameters is essential (most advisors expose their clients to more risk than those clients realize … until it’s too late and they’ve lost a lot of money). Rebalancing that portfolio regularly also helps and tactical overlays can be used to close out positions that are moving significantly in the wrong direction.
Investing means putting money at risk with the expectation of making gains. Any investment can lose money, but it shouldn’t have to lose so much that you can’t sleep at night.