This Simple Math That Could Make Or Break Your Portfolio

There had to be a few pages missing. This couldn’t be everything…

That was my first instinct when my father-in-law asked me to look over his investment portfolio.

As you’re likely well aware, things got messy during the financial crisis. Folks lost their homes, retirements, jobs — and many lost hope. And in my former life as a financial advisor, it was tough sitting across the kitchen table with many of these good people and listening to their stories.

If anything, it taught me a valuable lesson. Specifically, it taught me about the importance of portfolio management (especially when it comes to other people’s money). After all, big returns are great, but I’m more interested in how much I avoid losing during market declines.

Don’t get me wrong. I like finding the next big winner as much as the next guy, but seeing firsthand what a devastating loss can do to a portfolio made me acutely aware of what it takes to climb out of that.

A Difficult Conversation…

And here I was, reviewing my father-in-law’s portfolio. What I saw was more than just a little concerning.

He said he took a pretty big hit during the financial crisis. Of course, nearly everyone took a hit during that time. But one thing caught me off guard… I made the incorrect assumption that as a man closing in on 60, his advisor would have begun to trim down his equity holdings.

I was wrong.

He was 50% allocated in an aggressive growth fund containing domestic stocks and 50% allocated to a growth fund invested in European stocks. In other words, he was 100% invested in equities.

If that weren’t alarming enough, from the highs in 2007 to the low in 2009, the two funds that my father-in-law was invested in plummeted roughly 50%.

It’s sometimes hard for investors to grasp what that sort of loss means. That could be because of how we can manipulate numbers using simple math.

The Hard Truth About Your Portfolio

For instance, imagine that Investor A’s returns each year over a five-year period were 70%, 10%, 30%, 5% and -70%. To find the average most folks might use the arithmetic average. This adds the performance of each year up and then divides by the number of years. So in this example, Investor A might say he’s averaged about 9% returns over the last five years: (70%+10%+30%+5%-70%)/5 = 9%.

That doesn’t sound half bad. On a $100,000 portfolio, one might think that with an average annual return of 9% he’d have about $150,000 after five years.

But that’s not how it works out in real life…

Using that same example and computing the returns with the correct geometric average, we realize that Investor A’s average return paints a different picture. Because each successive term is dependent on the previous outcome, we must use the geometric average. This will provide us with the correct and real return an investor would make.

Instead of 9%, Investor A’s actual average return is -5.2%. Sound crazy? Trust me, it’s not. Here’s the math:
((1.7×1.1×1.3×1.05×0.3)^(1/5)-1) = -0.05, or -5.2%.

Here’s another way of looking at it:

Year Rate of Return Dollar Amount
0 $100,000
1 70% $170,000
2 10% $187,000
3 30% $243,000
4 5% $255,255
5 -70% $76,577

So instead of about $150,000 after five years, the portfolio value is about $76,577 — nearly half of what Investor A thought he might have.

And all it took was one abysmal year to wipe out five years of growth.

Here’s the simple mathematical truth you need to understand to be a better investor. A 50% loss requires a 100% return just to get back to even. Think about that. How many times have you bagged a triple-digit winner in a year or less?

The table below tells you what return you must achieve in order to get back to even after suffering a loss:

Loss

Return Required To Recover

-10%

11%

-20%

25%

-30%

43%

-50%

100%

-70%

233%

Closing Thoughts

Understanding losses and what it takes to recover from them is vital to building wealth over the long term. Remember, the power of compounding only works when you don’t lose money. One year of suffering a bad loss can take years to recover.

As William Lippman, the 90-year-old money manager for Franklin Templeton once said, “Better to preserve capital on the downside rather than outperform on the upside.”

In my father-in-law’s case, those funds didn’t recover until about five years after the financial crisis. And when you’re closing in on retirement, you can’t afford to lose five years.

That’s why I dedicate as much time as I can looking for rock-solid companies that should deliver consistent returns, year in and year out.

Understand that I’m not advocating that you move to all cash in times of crisis, or every time the market has a violent downswing. In my premium newsletter, Top Stock Advisor, I look at every downturn as an opportunity. It gives us the chance to pick up some of our favorite stocks at a discounted price. And because we have a plan in place for each holding, my subscribers and I can get a good night’s rest.

My plan isn’t to shoot for the moon on risky fly-by-night stocks. Instead, my goal is to find the absolute most dependable stocks the market has to offer. If you’d like to take charge of your portfolio and learn about my latest research, visit this link.