Why Losses Hurt More than Gains Feel Good: Part 2. Implications for Different Investors
In Part 1 of this series, we saw how any loss of a given percentage requires a larger gain (sometimes much larger) to recoup what was lost. This phenomenon is shown in the table below, with the right-hand column showing how much larger gains must be to offset various losses.
In this installment (part 2 of 3), we will explore the implications of the below phenomenon on some investors who generally fall at the green and red areas of this table. We’ll see how dangerous it is for retirees—at least those who draw money from their investments to live on—to have huge losses, and why they should attempt to limit portfolio losses to the upper part of the table (ideally portfolio losses under 40%). We’ll also look at speculators, who tend to live in the red section.
Table 1. GAIN/LOSS EQUIVALENCIES, AND GAINS RELATIVE TO LOSSES
Why Worry? Because We Will Be Wrong
You and I (and every other investor, even computer trading programs) are wrong part of the time. That’s because markets simply do not act exactly as they have in the past. No matter how much research you or I, or Viridian (my firm), or anyone else, can do—and no matter which historically reliable economic and market indicators we watch—we will still be wrong at times.
The future is full of surprises. The extent to which you are financially impacted by those surprises depends both on how big a surprise is (in this context, how much of your assets are involved), and whether it results in a gain or loss.
There are essentially four kinds of surprises:
Table 2. KINDS of SURPRISES
We don’t mind positive surprises, whether they’re small or large, and bad surprises (losses) aren’t so bad if they only happen with a little of our money. What we’re really trying to avoid is are the Big Losses, the ones that wipe out 60-90% of our total portfolio (i.e., in the red section of Table 1). The reason is that, as we saw in Table 1, small losses only take small gains to offset/recoup what was lost, but large losses are very difficult to recoup, let alone end up with a decent positive return.
Whether there is even a possibility of recovering from a huge portfolio loss depends on multiple factors, including:
- Your age: Do you have enough years to recoup it, and/or to make it up using future earnings and savings?
- Your risk profile: Are you psychologically and financially able to take the risks necessary to recoup the loss?
- Your cash flow needs: Can you afford to go with less or no income while you’re recouping the loss?
- Ability to withstand another huge loss: What if you suffer another loss of 60-90% while you’re trying to recoup the first one (because that could happen)?
A person who is young, has a high-paying job and hasn’t saved a lot of money yet, can probably afford to lose their entire savings (investment portfolio)…several times…and still build up their nest egg over and over again by the time they retire. For that person, operating in the red section of Table 1 (i.e., risking huge losses) might make sense. We’ve all heard of people who “lost it all,” but then made a fortune (Elon Musk, of Tesla and SpaceX fame, for instance). But you have to consider the four factors above, and how they apply to you. Let’s look at two categories of investor – speculators and retirees.
Implications for Speculators
Take a look at the red section of Table 1 and what it takes to recoup an 80% loss. You need to make 400% just to offset one 80% loss. And a loss of 90% requires a 900% gain to just get back to square one. Looked at another way, if you put all of your money in a hot new tech stock that shot up nine times your investment (+900%) return, and then you put that money in another stock that fell 90%, the latter would wipe out the entire gain from the first one. That’s why speculators, who often operate at such extreme risk levels, face such challenging odds.
Soon after I entered the investment business 40 years ago, I read John Train’s excellent book, Dance of the Money Bees. One section of that book addresses commodities (futures) speculation, which is, as Train puts it, “no place for the investor…almost nobody makes money over a long period in commodities except the brokers…you haven’t got your money in something that’s intrinsically building, but rather in a gambling game where you can never get an edge.” You can certainly see how people involved in extremely risky speculation (e.g., futures and options) end up getting “wiped out,” even after a tremendous run of successes.
When the dot-com bubble burst in early 2000, the NASDAQ index, which was (and still is) heavily weighted toward technology stocks, lost 77.9% of its value in the ensuing bear market. If you look where that size of loss fits in Table 1 (near the 80% loss level), you know that the NASDAQ had to more than quadruple in value from that low point to recoup its loss. It did so, but it took more than 14 years…with no return!
I’m not saying that we’re in another dot-com bubble now, but there are almost always individual tech and biotech stocks that are as overvalued as the NASDAQ was back then…and could fall just as far. If you speculate in such stocks (and/or in commodity futures or options), make sure it is with relatively small amounts of your total portfolio, so that when one doesn’t work out, it’s only a small portion of the total. That is especially true if you are near or already in retirement.
Implications for Retirees
A retired person who is dependent on their investments for monthly living expenses doesn’t have the years, the risk profile, or the ability to go without income that are necessary to recoup huge portfolio losses. That doesn’t mean they should take no risks, merely that they need to take risks that, when negative surprises strike (because they will), they have a relatively small impact on their total portfolio. Ideally, they should generally stay in the green section of Table 1 (losses less than 30%).
For example, if a retiree buys a small company tech stock with 2% of their portfolio, and the company goes bankrupt, they’ve only lost 2% of their money. Whatever return the rest of the portfolio made, the bankrupt stock just reduced it by 2% that year—a small enough loss to easily recover from.
Breaking Even Is Not Enough
Note that Table 1 represents only “break-even” results, i.e., recouping a loss, but ending up with no return for the time involved. To have a positive return requires even larger gains. This is especially problematic for retirees, who generally draw money from their portfolios each year to live on. This can be clearly illuminated with an example.
Meet the Smiths, a retired couple who (for purposes of this illustration) have their entire $1 million of savings in stocks. The Smiths hang onto their stocks through a 50% bear market, which lasts 2½ years, as well as a 3½-year bull market that follows (both fairly typical time periods). During the bull market, stocks go up 100%, which we know from Table 1 is exactly the amount necessary to recoup the 50% bear-market loss…at least for investors who leave all of their money in the market.
What makes the Smiths different is that, during the bear market decline and the bull market recovery, they not only have no net return, but they are drawing out money to live on each year. Let’s assume that the Smiths draw out $40,000 every year. That is 4% of their portfolio’s starting value (4% is generally the maximum that most retirees should draw if they wish to maintain their principal).
Unlike in Table 1, after a 50% bear market loss, the Smiths’ portfolio will not get back to $1 million of principal with a 100% bull market gain. They need the bull market to go up considerably more than 100%. Here’s why:
- When the bear market reaches its bottom (down 50%), their $1 million portfolio is actually down 60% ($600,000), so it is only worth $400,000. The reason?
- It dropped 50% ($500,000) due to the bear market, plus
- They withdrew $40,000 per year for 2½ years ($100,000) to live on.
- Referring to Table 1, we can see that a 60% decline (while it doesn’t seem much worse than 50%) requires a lot bigger gain to recoup the loss—150% instead of 100%.
- But the Smiths also draw out $40,000 each year during the 3½-year bull market recovery, so that’s another $140,000 that they need to recoup.
- Note that the $40,000 a year that they are drawing during the bull market isn’t 4% anymore (as it was relative to their starting $1 million).
- Instead, as a percent of the portfolio’s $400,000 value at the bottom, $40,000 is a whopping 10%!
- Summing it up, when they have $400,000 at the bottom of the bear market, they will need to gain $740,000 to get back to $1 million:
- $600,000, which is 150% of $400,000 (as explained in B above), plus
- $140,000, which is 35% of $400,000 (as explained in C above), which all adds up to
- $740,000 total, or 185% of $400,000.
Because the Smiths drew $40,000 out each year to live on, instead of needing the market to double (gain 100%) to get back where they started, they need the market to almost triple (go up 185%!).
For most retirees, suffering a severe bear market like the Smiths did, or any other huge loss of their total portfolio, raises several challenges:
- In real life, there is a high probability that, seeing such large declines, many retirees will panic and sell some stocks while they’re down, meaning they will get less than the full benefit of the next bull market, not more (which they need to recoup the loss).
- Because the Smiths were drawing out money each year to live on:
- The gain they needed in order to recoup their loss is considerably more than someone not drawing money out.
- This was exacerbated by the fact that they continued drawing out the same dollar amount each year, despite the fact that their portfolio value was dropping. If the Smiths, instead of withdrawing a constant 40,000 dollars each year, had reduced their withdrawals to maintain a 4% portion of the portfolio each year (i.e., withdrawing less than $20,000 when it was worth less than $500,000), they would have benefitted in several ways:
- They would have had less than 60% ($600,000) to recoup at the bottom (as explained in B above);
- They, therefore, wouldn’t have needed 150% gain to offset the loss; and
- They would have come closer to recouping the loss during the bull market that followed.
- While failing to recoup the full amount of the loss (185% in the case of the Smiths) might just mean that there is less money left after they die to go to their heirs, and it does not necessarily mean that retirees can’t still live comfortably the rest of their lives, it certainly might impact their ability to do so.
Important Guidelines for Retirees
The Smiths example highlights several principles/guidelines that apply to most retirees:
- Retirees should allocate their investments with enough money outside the stock market (e.g., in bonds, real estate, etc.) that:
- When bear markets occur, their total portfolios don’t suffer declines of 40% or more, and ideally lose less than 30%. (We will discuss some tools/ways to accomplish that in Part 3.)
- They have enough of their portfolio in bonds, cash, CDs, and/or other liquid and low-volatility investments to cover withdrawals they will need to live on through an entire bear+bull market cycle (typically 4-6 years), without having to sell stocks while they’re down.
- Put another way, because it is important that retirees not panic and sell their stocks when a bear market is at its worst, they should:
- Only have money in stocks that they will not need to touch/withdraw for at least 4-6 years (by which time a full bear and bull market recovery cycle normally will have occurred).
- Appropriately allocate their portfolio before the next bear market occurs, so that they can weather that bear without panicking. Concluding that you have too much money in stocks during a bear market somewhat defeats the purpose.
- Recognize that doing these things will result in lower portfolio returns during bull markets (than higher stock allocations would), but the tradeoff is well worth it.
How Much Risk is Too Much?
The above discussion might leave you wondering if you should just keep all of your money under the mattress, or in investments with little or no risk. However, that is partially because the Smiths example assumed that they had 100% of their money in stocks, which is seldom a good idea for retirees. But neither is having no money in stocks.
Remember that risk and reward go hand in hand, so your goal shouldn’t be to avoid all risk (which unfortunately also guarantees low returns). Instead, your goal should be to only take risks that are appropriate for you (based on your age, circumstances, goals, personality, etc.).
If you won’t need to tap your savings for many years—or if there is some portion of your savings that you won’t need to access for many years—having that money in the stock market is perfectly prudent. In fact, it is appropriate and advisable for most retired investors to keep a portion of their money in stocks, in order to have a better chance of the portfolio keeping pace with inflation. The long-term returns of stocks should be considerably higher than that of investments with little or no fluctuation and risk. You just probably shouldn’t have money in stocks that you’ll need to spend within 4-6 years.
Get Help if You Need It
Watching the value of your investments fall during bear markets is emotionally difficult, and that is in part because losses do hurt more. If you’re like most people, you could use the steady hand of a good financial advisor to:
- Help you create a Personal Financial Plan (PFP) to serve as a roadmap for reaching your long-term financial goals, including how much you need to save, what you can afford to spend in retirement, how much risk is appropriate for you, etc.
- Help you allocate your investments among an appropriate mix of asset types, with proper risk and realistic returns to achieve the goals in your PFP, taking into account your emotional tolerance for risk, and providing for current and future income needs. That means diversifying and limiting the risks to which your money is exposed.
- Help you maintain the discipline necessary to stick with your Plan, including not panicking during market downturns.
The bottom line is that you should make sure that you’re comfortable and confident that your assets are allocated appropriately for your goals, time horizon and cash flow needs. The key is not taking more risk than you can really afford, ideally limiting your overall portfolio risk to the green or yellow (if you can afford more risk) sections of Table 1, since that will make recouping losses far easier when they do occur. A good financial advisor will help you do that. In fact, I highly recommend that you discuss these concepts with your own financial advisor (and, if you’re not currently a client of Viridian, share this article with them).
In Part 3, we will look at some of the specific disciplines and tools to help limit or mitigate risk…many of which we use at Viridian in managing clients’ portfolios. They should help you steer clear of that red section of Table 1, and sleep better knowing that you’ve done so.
Author’s Note: This 3-part series is excerpted from my upcoming book, The Reluctant Investor.
Viridian is an SEC Registered Investment Advisor (RIA) with clients across the United States. Viridian offers financial planning, investment management, and tax services (through its sister company, Viridian Tax and Accounting). Bruce Yates has been a fiduciary financial advisor for almost 35 years, and he is one of Viridian’s four Founding Shareholders.
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