The only loss that matters
On March of 2000 the stock market (as measured by the S&P 500) was just about at its peak at 1,464. Then the dot.com bubble burst and the market declined to a low of 841 on February 28, 2003. A decline of 42%. Perhaps you remember that? It was scary, un-nerving, and depressing. But if you had bought at the peak and NOT sold on the way down, did you lose anything?
That’s the problem with investing. Our financial statements show the value of our investments in real time, on that day. And what is the value they represent, the value of the last trade, the marginal buyer. Not really the value of the underlying company, the products they sell or the assets they hold.
The only real loss is the loss that’s realized when you sell an asset for less then you paid for it.
If you had a big windfall, perhaps a rich uncle passed away and gave you a nice chunk of money, and you decided to invest it for your retirement and you did it at exactly the wrong time, August 2000, but did not sell in the dot-com bubble or 2009 in the “great recession”. What would that investment be worth today, 20 years later? About $200,000. That’s a 100% gain in 20 years or an annualized return of about 3.5% and that assumes you made a big investment at EXACTLY the worst time.
Plus, let’s not forget about dividends. Every year, the income from that investment would increase. From around $2,000 per year to about $4,000 today (the S&P has averaged 2% per year dividend). If you had re-invested those dividends, your balance today would be just about $300,000 (this assumes a tax-sheltered account for simplicity)
What’s the takeaway … the best way to avoid losses is to not sell when the market is down. And, you can’t profit from the gains if you are not in the market. While this is a remarkably simple answer, in practice it is soooo hard to do. Let’s look at why.
History of stock market losses
Financial markets are rational and guided by specific principals and patterns. This idea is certainly counter intuitive. Popular culture and the financial media have taught us to believe the exact opposite. That markets are ruled by chaos and any order we might perceive may cease to function at a moment’s notice.
The rationality of the markets is widely skewed in the short term by human emotion, specifically euphoria and fear. The rationality of markets can only be understood when considering the long-term investment horizon. As we extend our vision and time horizon, the unpredictability begins to fade, and the rational order becomes clear.
It is unclear why most investors live in constant fear that they will lose money in the stock market, given that the equity markets have never produced a permanent loss of capital when given enough time. While markets have declined sharply on many occasions, the average bear market over the last 90 hears has taken about 40 months to go from peak to trough, and then back to the prior peak. However, during other times, the markets have also risen sharply.
You are your own worst enemy
Emotion is the enemy. Yours, your brothers, your friends, and even your financial advisors. To invest successfully you must match the investment to the proper time horizon. What do you need to spend in the next year, the next five years, and what do you want to have available to you and your family in 10 years, or 20 years, or 100 years?
To master this requires a healthy does of these two essential skills:
- Patience – the ability to refrain from reacting during protracted periods when your strategy is not working or doing nothing
- Discipline – the ability to adhere to your strategy over the projected time period
The investor who truly understands the impact of time, and who accurately targets investments to the proper time horizon, can simply play the probabilities and not rely on market predictions or prognostications. They can simply play the probabilities and use low volatility asset classes for goals with a short duration and more volatile, high growth assets for goals with a longer duration. Then sit back and wait (and enjoy).
Develop and execute a WRITTEN wealth plan
Once you’ve identified your goals, your expenses, and sources of income, it’s time to sit down and put it all on paper in the form of a written financial plan. It has been said that failing to plan is planning to fail. People who sit down and design a date-specific, dollar specific written wealth plan have a much greater chance of building and preserving wealth then those who don’t.
The simple truth is that all long-term investment success comes from acting on a plan, while all failure is precipitated by reacting to the markets.
No matter how long you live, or how much you accumulate, there is likely to come a day when you will retire and harvest your wealth. When that day comes, there are only two options:
- The money outlives you
- You outlive the money