One step back, two steps forward. This axiom informs most people’s perceptions of loss recovery—if you gain an amount double that of your losses, you will get ahead. Unfortunately, when it comes to investment losses, one step backward requires at least three steps forward, and often many, many more.
This is because the percentage gains needed to recover from a loss increase exponentially as losses increase. In a market crash, stock prices can plunge drastically in short order. Investors need to understand the risk of taking on greater losses, and the related consequences of a buy-and-hold strategy.
The Relationship Between Losses and Percentage Gains
The basic formula to determine what percentage gains are required to make up for given loss is: x / (1 – x) = y or dollars at Start –Dollars lost=Dollars left; then dollars lost/dollars left.
The effect is compounded as losses increase so that:
- A 10% loss requires an 11% gain
- A 15% loss requires a 18% gain
- A 20% loss requires a 25% gain
- A 25% loss requires a 33% gain
- A 50% loss requires a 100% gain
- A 75% loss requires a 300% gain
- An 80% loss requires a 400% gain
- An 85% loss requires a 567% gain
Watch what happens once losses move into the last 15 percent.
- An 86% loss requires a 614% gain
- An 87% loss requires a 669% gain
- An 88% loss requires a 733% gain
- An 89% loss requires an 809% gain
- A 90% loss requires a 900% gain
The difference in gains needed to recover from a 75 percent and a 90 percent loss are astronomical. The former might be recoverable within the investor’s lifetime. The latter is not. Investors who choose to ride out market crashes are jeopardizing their retirement.
One of the best ways to practice risk management in relation to assets is to withdraw from the market either before the crash or after moderate (15-20%) losses and, as the expression goes, “live to fight another day”. This strategy also ensures you’ll have cash on hand to buy when the markets are low.
No strategy assures success or protects against loss.
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