The arithmetic of loss

“Good judgment comes from experience and experience comes from bad judgment.”  I’m not sure who said that, but it sure is true.  When considering investment lessons learned from the financial train wreck of last few years, many people at or near retirement are likely to put the arithmetic of loss at the top of their list.  Unfortunately, this knowledge (like that gained from touching a hot stove) usually comes at a painful cost.  

To see what I mean, imagine you had a $1 million portfolio that lost 20 percent, or $200,000, in a given year.  Gaining 20 percent the following year would not get you back to even.  A 20 percent gain on $800,000 would only get you to $960,000.  You would need a 25 percent gain to fully recover from a 20 percent loss.  The greater the loss, the more difficult it becomes to get back to even.  If you lose a third of your portfolio, you need a 50 percent gain to recover.  Losing half of your portfolio means that you would need to double your assets just to get back to where you started.  Those types of gains take time, which is fine if you have thirty years to go until retirement, but not if you have three.

When you understand the math, it is easy to see that one of your primary concerns as you approach and enter retirement should be avoiding large losses.  Large losses are extinction level events.  They are like meteors to dinosaurs.  They can wipe you out.  All else being equal, the closer you get to retirement, the more conservative your asset allocation should be.  Take a minute to review your allocation.  Is it appropriate for your circumstances or is it the financial equivalent of “Put it all on red”?

Photo by Anssi Koskinen.  Used under Creative Commons License.

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