Infinity Isn’t Everything. 100 Percent Is.

Think of it this way – assume you play the market and get every single bet right. Just as the markets start to go up, you buy at the very bottom and wind up picking all the best-performing stocks, using borrowed money (leverage) to amplify your returns. Just as the markets start to go down, you sell at the top, shorting all the worst-performing stocks while leveraging those shorts to the hilt. In effect, you are generating exponential, near-infinite returns.

Then, one day, your luck runs out. The company you invest in goes bust and you suffer a 100% loss – actually, significantly more than a 100% loss since you were leveraged.  Despite numerous “wins” totaling percentage point gains in the tens or even hundreds of thousands, it only took one loss – just into the triple digits, percentage-wise – to wipe you out and then some.

But losses do not have to be that extreme to devastate your retirement portfolio. Consider this – an investor buys into the “New Economy” meme back in March of 2000 and loads up on shares of a NASDAQ index fund in their IRA. As of the time of this writing, their account would still be down about 45%!  That means their portfolio would need to almost double just to get back to where they were over twelve years ago!

The folks at Crestmont Research (www.crestmontresearch.com) ran the numbers and found if a portfolio can break even in months when the market is down, it needed to capture just 30% of the markets’ up-month returns to keep pace. If a portfolio declines half as much as the market in its down months, it needed to capture just 64% of the market’s up-month returns to keep pace. As Crestmont’s Ed Easterling observes:

“For some, these concepts and the related performance may not seem to follow conventional wisdom. Our perceptions are often shaped by what we read in the press or hear from traditional sources. In 2002, for example, as the stock market declined and total returns were -22%, the story headlines about hedge funds often read: ‘Hedge funds fail to deliver returns.’ Story after story explained that hedge funds were near breakeven.

“The following year, as markets soared and total returns were +28%, the same sources reported: ‘Hedge funds can’t keep up.’ The stories told how hedge fund returns were just over half of the market’s gains. Little attention — except by hedge fund investors, however — was paid to the fact that traditional portfolios remained with net losses across the two years, while the accounts of many hedge fund investors had grown by almost 20% over the same two years.

“The impact of losses is significant to investments and portfolios. That impact is greater than a similar percentage gain…and that impact grows as the magnitude of losses increases. A key value of the hedge fund style of investing — so called ‘absolute return’ investing — is its focus on controlling downside losses and capturing a reasonable share of the upside. As the analysis and studies have shown, as downside risk is controlled, not only does it provide investors with a reduced risk profile and more comfortable ride, but also it requires much less of the market’s upside to deliver the same level of return.”

For more examples of why boring is beautiful when it comes to investing, please go to http://www.tortoiseretirement.com/be-the-tortoise/.  As always, if you have any questions about your portfolio or the markets generally, please feel free to contact me.