Softening the Harsh Arithmetic of LossAdvice to the Advisor
Sometimes serving as an advisor can feel like teaching a course about cancer to medical students. When it comes to investments, it might be said that the market itself is the greatest of teachers, but that attending class isn’t always fun. Just as those doctors-to-be, learning about the ravages cancer can cause, persist in hoping the lesson applies to others, never to themselves, your clients tend to persist in their denial of the arithmetic of loss and the potential devastation down markets can cause in their portfolios.
The harsh reality of the arithmetic of loss is that a given percentage of gain is never going to be enough to recover (return to the break-even point) from a loss of that same percentage. The chart below shows a starting portfolio of $100,000 that suffers a loss of 10%. An 11.11% gain will be required to “grow back” to the original portfolio value. To recover from a 30% loss, the portfolio would need to increase 42.86%, and so on….
Of course, the flip side of the arithmetic of loss, you hasten to assure clients, is the arithmetic of gain. The Standard & Poor’s 500 Index hit more than 200 all-time highs in this decade alone, as Ben Carson points out in Fortune, following one of its worst ten-year periods with one of its best. (The S&P was up nine out of ten years—(2019 was the only down year with a loss of just 4.2%).
Capital Management Group’s Investor Education Series’ introductory paragraph is enough to make students sit up—and shake: “It’s a little-known but startling fact: Since 1901, the Dow Jones Industrial Average has spent 76.4% of the time declining in value or recovering from loss and just 23.6% of the time creating wealth.”
The current year has been an arithmetic lesson in itself, Sheaff Brock Managing Partner Dave Gilreath points out, modeling the greatest degree of volatility of the current decade, with the greatest number of daily moves of 1% or more since 2009.
One understanding towards which you may have nudged your clients relative to market volatility and the arithmetic of loss may well be this: their best bet is remaining invested in the market at all times to avoid the risk of missing the best days. A tried-and-true discussion model is the well-known best-day/worst-day overview:
The S&P 500 annual growth rate between January 1, 1995, and September 30 of the current year, for example, was a solid 8%. Take away the best 20 days of those 25 years, and the annualized return drops to a mere 2.7%. Were investors able to predict—and avoid—the ten or twenty worst days, the positive effects would be even more significant.
For those still fixated on the promise of timing, Gilreath calls attention to the fact that those best and worst days have historically been clustered together, as shown in the chart below. “Hopeful” client denials notwithstanding, he stresses, it’s difficult to escape the conclusion that timing the market is a fool’s game.
With the national election upon us, as you’ve undoubtedly experienced, clients are unusually risk-sensitive, reluctant to make significant portfolio decisions, at the same time fearful of increased volatility over the months and quarters to come.
One approach to reducing your clients’ anxiety about the stock market? Gilreath suggests that, if their investments are causing clients to lose sleep at night, advise them to simply reduce the amount invested by selling when the market is high. Otherwise, encourage them to stay invested—there will be a few bad days, but the long-term results will mean they reap the benefits of the best ones, too.
Like medical students in denial of their own health vulnerability, investors ignore mathematical truths at their peril. But, as good teachers, advisors can guide them towards a long-term view of the market, encouraging them to take a deep breath and stay invested to help soften the arithmetic of loss.