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The Big Impact of a Large Loss on an Investment
One sharp downdraft can have a considerable impact on an investment’s returns. This is because compounded returns are not symmetrical. The price of an equity can still be materially lower than it had been, following an earlier steep loss, even after the investment posts a strong recovery in a subsequent period. Let’s look at this concept: the math behind this idea makes it easier to understand; For example, a 50% loss in value one year takes a 100% gain the following year to recover. What’s more, if you lost 75% in value on your investment, you would need a 300% advance to offset the original loss. Considering big gains are generally hard to come by, it is paramount to focus on avoiding steep losses. Indeed, one large loss can wipe out an investor’s returns for years to come. For instance, that same 50% decline would take annual gains of about 26% over three years to recoup. Therefore, investors should be careful not to take unnecessary risk, especially when the stock market is experiencing heightened volatility. The market can be forgiving on some mistakes, such as missed opportunities, but a deep loss in equity valuation is less tolerated. Investment returns can be dragged down over an extended time period for this mistake. However, this does not mean investors should cram their savings under the closest mattress to avoid this possibility. They should just be careful about the risks they take. When analyzing an investment, investors should weigh the risks against the possible rewards, paying proper attention to the potential for a steep decline.