The Bee Cave Bee

The third in a series of articles from our friends at Halbert Wealth Management:

Many people assume that if they lose money in the stock market, they have to make an equal gain to get back to breakeven.  Thus, they reason that a 20% loss would require a 20% gain to get back to where they started.  Unfortunately, this isn’t the case; it takes a gain of 25% to recover from a 20% loss.  Even worse – the more you lose, the greater the return required to bring you back to breakeven.

Perhaps this is why legendary investor, Warren Buffett, has said, “The first rule of investment is don't lose.  And the second rule of investment is don't forget the first rule.”

Let’s take a real-life example to illustrate Mr. Buffett’s sage advice.  Much has been written about the recent bear market in stocks and the huge rally in 2009.  After reaching a record value in October of 2007, the value of the S&P 500 Index fell over 57% by March 9, 2009.  This peak-to-valley drop is known as a “drawdown.”  From April through December 2009, however, the S&P 500 rallied over 65% - surely enough to compensate for the earlier 57% drop, right? 

Wrong!  As of the end of 2009, the S&P 500 Index was still far under its October 2007 value.  In fact, it was still under its December 31, 1999 value, which prompted financial journalists to coin the term, “the lost decade.”  From its lowest point in March of last year, the S&P 500 Index had to gain 133% to get back to breakeven.  So, the 65% rally was a good start, but only about half of the gain needed to make up lost ground.

As noted above, the problem with negative investment returns is that the greater the loss, the higher the return required just to get back to breakeven.  Lose 30%, and you have to gain 43% just to get back to breakeven.  Lose 50%, and you have to gain 100% to erase your loss.  The following graph provides a visual representation of the exponential relationship between losses and subsequent gains to get back to where you were:

Since many passive investment strategies mimic the broad market stock indexes, it’s not hard to believe that many people are still under water in their investments, and may be there for some time to come.  For this reason, many investors are seeking out alternative investment strategies that seek to minimize investment losses rather than ride them out.

Once available only to wealthy individuals and institutions, alternative investment strategies are now available to a much wider range of investors through the use of specialized mutual funds and exchange traded funds (ETFs).  In the coming months, we’ll be writing more about these specialized strategies and how they can enhance portfolio diversification. 

Halbert Wealth Management, Inc. (HWM) is a Registered Investment Advisor based in Bee Cave, Texas.  As a “Manager of Managers,” HWM matches investor needs to a nationwide group of third-party professional money managers.  HWM seeks out strategies that can reduce the risk of investment losses while providing reasonable returns.