How Future Losses Erase Prior Gains

Someone was talking about how much the stock market is “up”.

However, it’s the exit that determines the outcome.

When someone talks about being “up” that doesn’t mean anything unless they have sold to realize the profit.

If they haven’t sold, it’s the markets money. The market may giveth, but it can also taketh away. Market gains are just market gains. To realize a profit, we have to sell.

Open profits aren’t yet realized.

Open profits may never be realized.

Open profits may be evaporated by later losses.

Closed profits are ours. When we exit and take a profit, we’ve realized the gain and have the cash to show for it.

To be sure, let’s look at the last 20 years. It’s hard to believe that a data point of 1997 is now 20 years ago! It seems like yesterday to me. Talking about 1997 may sound ancient now, but it wasn’t so long ago. The late 1990’s was one of the strongest cyclical bull markets in history. The S&P 5oo stock index gained over 200% in five years! The sharp gains of the late 1990’s inspired even the oldest bank savers to cash in CD’s that were paying 5% to 7% for the chance for high profits.

Only in hindsight do we know what happened next.

An essential concept investors must understand is not only how capital compounds, but also the math of loss.

Losses are asymmetric. In fact, losses are more asymmetric than gains.

That is, losses compound even more than gains.

Losses are exponential. As they get larger, it takes more gain to recover the loss to be back to even.

That’s why we don’t have to capture 100% of a gain to result in the same or better return if the downside loss is limited. When we avoid much of the downside, we simply don’t need to risk so much on the upside to compound capital positively. And, if we don’t have large losses on the downside investors are less likely to tap out with losses. Those concepts are essential to understand. It doesn’t matter how much the return is if the downside is so large they tap out before the gain is realized.

In the chart below, we can see how the math works.

A -10% loss takes +11% to recover. A 20% loss takes +25% to recover. Beyond -20%, the losses become more asymmetric and exponential. A -30% loss needs a +43% to get back to even. At -40% you need +67% to regain. That’s why losses in the -50% range as we’ve seen twice over the past 15 years are so devastating to life plans. At -50% you need +100% just to recover the loss and get back to breakeven. If your loss is -60%, it’s +150% to recoup. So when you hear people bragging about the stock market gains since 2009, don’t forget the other side of the story. It’s the other side the makes all the difference. How many years of staying fully invested in risky markets did it take to recover the loss?

Let’s look at how this matches up with real price trends we’ve observed over the past 20 years.

Below we see the late 1990’s gains more than erased by the sharp decline from 2000 to 2002. But keep in mind, while the decline was a sharp one at -50%, the decline was made up of many swings up and down along the way. The swings of lower highs and lower lows swayed many investors back “in” as those swings up along the way made them think the low was in and it was a “buying opportunity”. They did that just in time for the next down move. Avoiding bear markets isn’t as simple as exiting near the peak and reentering near the low. It’s far more complicated as investors fear missing out during every 10% to 20% uptrend, the fear losing more money after another -10% to -20% downtrend. But, the point here is that the large uptrend was erased by the later downtrend. What happens along the way brings additional challenges.

After the low around 2003, a new cyclical bull market began. As we know in hindsight, it lasted until October 2007. In October 2007, investors were pretty optimistic again and maybe a little euphoric. Stocks had gained over 100% from the bear market low and they wanted more stocks. It didn’t take long for a decline large enough that more than erased all the gains they were so excited about.

In fact, not only did that bear market erase the gains of the cyclical bull market that started in 2002, it also erased all of “The Tech Bubble” gains going back to 1995! By 2009 the past fourteen years was at a loss for stock index investors.

Even the largest uptrends have been erased by the later downtrends. This has happened many times in stock market history.

It doesn’t matter how much the stock market had gained. It only mattered if the profits were realized. Otherwise, it was just a rollercoaster.

You can probably see why I say that markets have profit potential, but because they don’t always go up, they require risk management. It’s why I actively manage risk and apply directional trend systems intended to capture profits and avoid significant losses.

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