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When it Comes to Surviving a Bear Market, Not Losing Is Winning
One of billionaire investor Warren Buffett’s most famous quotes is: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
As investors, we know there will be up years and down years. The short-term risk of stocks is the price we pay for long-term returns. However, this is contingent on not turning paper losses into real losses.
Selling at a low or using overly risky strategies like market-timing can be catastrophic to your long-term returns due to a simple mathematical fact.
It’s not only about what you make. It’s about what you keep. This is true for accumulating wealth and it is very true for your portfolio too. Risk mitigation, or losing less during down times, is essential for your portfolio to grow.
This is a very valuable math lesson. Your portfolio needs a greater gain to break even after a loss occurs. The larger the loss, the exponentially higher return is needed.
On a dollar basis, this may not seem like a big deal. If you have $100 and lose $50, you will need $50 to break even again. But when viewed as a percentage – when you lose 50% of your investment, you will need a gain of 100% to break even. How often does the market hand us 100% returns? Not often.
The recent pandemic bear market showed us a real-life example of how this can play out.
The S&P 500 dropped nearly a third of its value from the start of the year (3,230) to March 23 (2,237). At the time of this writing, the index has rebounded close to its January values, but the Dow Jones Industrial Average fared worse. It began the year at 28,868, and fell a catastrophic 34% to 18,591 at the low on March 23.
Investors in large-cap domestic stocks shouldn’t despair since the DJIA rebounded nearly 40% by the end of the second quarter. This isn’t enough to break even to where we started the year; that would need a gain of 54%. The index is still down year-to-date, but such a rapid turnaround is impressive, especially in a span of just four months. At the time of this writing, the DJIA is only about 7% short of break-even.
It always takes a greater percentage gain to recover from a loss: That’s an important lesson to keep in mind as an investor.
Recovering From Big Losses
Big losses are hard to recover from. The math of percentages shows that as losses get larger, the return necessary to recover to break even increases at a much faster rate. For example, say you invested $100, and lost $10, or 10% of your investment. You would be left with $90. A loss of 10% necessitates an 11% gain to recover, because 10% of $90 is just $9, as opposed to the $10 you would need to break even. Increase that loss to 25%, or a $25 loss from your original $100, and it would take a 33% gain on your remaining $75 to get back to break-even.
A 50% loss requires 100% gain to recover, and an 80% loss necessitates 500% in gains to get back to where the investment value started. This math holds true no matter what the dollar amount of the investment is: $100, $1000 or $1 million. The math is not in your favor and the larger the percentage loss, the more it exponentially hurts your portfolio.
When a bear market hits, it may take a while to recover. But the power of compounding returns helps investors. For example, say a bear market depleted your stock portfolio down to 70% of what it was previously worth ($70 from the original $100 example). A 10% gain returns the portfolio to 77% of its value, or $77. The next 10% allows the portfolio to recover to nearly 85%, or $85. Two more years with a 10% gain put the portfolio back to 102.5% of the value before the drop, or $102.50. So a 30% drop necessitates a 42% recovery, but 10% a year compounded for four years puts the account back into profitable territory. Compound interest is a wonderful thing.
Proper Portfolio Diversification
The math lesson of stock market losses illustrates how investors must protect themselves against big losses. Proper portfolio diversification is the first and most important step. Avoiding market-timing strategies is also very important, as missing even a single day can destroy your chance at recouping losses. This spring, new investors learned the hard way just how volatile stocks can be. Hopefully, they also learned the value of a market on sale, and bought a wide variety of assets with a long-term financial strategy in mind.
Diversifying appropriately within the asset allocation is essential. Finally, use a disciplined strategy to rebalance. Part of this includes following another piece of Buffett’s advice “to be greedy when others are fearful” and buying assets at a low. All of this together helps to mitigate losses and puts the odds in your favor to recover from a bear market successfully.
