Math Matters Principle 2
The miracle of compounding growth depends on a constant rate of growth. Losses, or negative returns, can throw an investment plan off course and severely impact the ending value of the investment. And just like compounding growth impacts wealth in an exponential fashion, so do losses.
Larger Losses Require Greater Gains to Recover
While losses increase in a straight, linear fashion, the gains needed to recover from those losses do not; they grow at an exponential rate. The deeper the hole, the more difficult it is to work your way out of it. The table below shows this principle with an initial $100,000 investment:
The bigger the loss, the greater the gains, and the more time, needed to recover those losses.
The Upside to Minimizing Losses
Missing the worst quarters has a more positive impact on your end financial goal than a pure buy-and-hold investing approach. Seeking to avoid big losses performs better than a pure buy-hold strategy. This is the result of the two combined math principles: power of compounding and avoiding large losses.
Large losses can occur much more quickly than large gains (compare the loss of the 2008 bear market to the gains of the 10 year bull market) and can wipe out years of investment growth in just a few months.
Minimizing losses is more important to the ultimate success of an investment plan than maximizing gains or chasing returns.
The Pain Index and the Importance of Avoiding Large Losses
We believe the pain index serves as a better measure of risk than standard deviation because it aligns with how investors understand risk: the risk of losing money. Learn more about the pain index in the video below: