Wednesday, May 13, 2009

Why Losing 20% is Better Than Losing 40%

Nobody wants to lose money. Let us assume that we have two hypothetical investors. One investor likes to invest on their own and they do not have a history of moving to cash. Instead, they choose to stay fully invested through both bull and bear markets. We will call this investor Foolly Investor.

The other investor is more conservative and does not risk as much in the stock market. This investor has read my book and limits his investments in any one asset class to 20% or less. In addition, they learned by reading my book, that they should never have more than 65% in stocks or equities. Particularly, they learned that 65% is an aggressive position and they are conservative and may only put 50% into stocks or equities. We will call this investor KYATMA Investor.

Foolly Investor was a fool to have 80 to 100% in stocks or equities. Foolly Investor's first mistake was investing based on only bull market possibilities. He failed to realize that markets not only go up, but they also go down. In addition, he did not understand the dynamics of investing with regard to the range of possible returns. Fooly Investor did not know that if a mix of investments has the potential to fall within a range of 0 to 25% on the upside, it has the potential to lose 0 to 50% on the downside. There is not an equal distribution of returns above zero and below zero. A fully invested portfolio will accelerate it's losses on the downside in a bear market environment. More people are selling in a bear market which compounds the losses on the downside. Foolly Investor only looks at the upside performance possibilities and completely neglects the possibilities on the downside.

KYATMA Investor is smart now that they have the knowledge packed into my book, Keep Your Assets Take My Advice. KYATMA Investor understands that when investing, you have to invest for both good and bad markets. In addition, you have to have a plan and a process that you follow. KYATMA Investor's plan is to diversify across many asset classes such as Large Company, Mid Cap Companies, Small Companies, International, Emerging Markets, Precious Metals, Commodities, Real Estate, Short Term Bonds, Intermediate Term Bonds, Aggregate Bonds, Treasury Inflation Bonds and Cash. In addition, he limits his exposure in each of the assets classes to the scale of limitations described in Rick's book.

KYATMA Investor ignores the recent bad press that says Asset Allocation does not work, because he understands that the people espousing that opinion have a hidden agenda. KYATMA Investor knows that a properly designed Asset Allocation does work, because he has had positive experiences in both bull and bear markets.

In the recent bear market of 2008, Foolly Investor lost 40% of his investment. KYATMA Investor lost 20%. Normally, Foolly type investors would think that KYATMA out performed Foolly by 20%, because their 20% loss minus Foolly's 40% results in a difference of 20%.

However, KYATMA's followers know their math. KYATMA followers know that if they outperformed Foolly on the downside by 20%, then this means that Foolly has to make about 40% just to catch up to KYATMA. That is assuming of course that KYATMA does not make anything while Foolly is making that 40%. KYATMA knows that if Foolly is making 40%, then KYATMA will also be making a good return. Therefore, the real number of Foolly catching up to KYATMA would be even higher than 40%.

Oh by the way, to recoup KYATMA's original investment, KYATMA only has to make 25%. Foolly has to make 66.67% to recoup their original investment.

Let us do the math, shall we?

  • KYATMA has $100,000 and Foolly has $100,000 to start.
  • KYATMA loses 20% so they are left with $80,000.
  • Foolly loses 40% so they are left with $60,000. (Foolly foolishly believes that KYATMA only outperformed him by $20,000.)
  • In order for KYATMA to get back to $100,000, they would have to earn 25%. ($80,000 x 25% = $20,000 added back to the $80,000 makes KYATMA whole at $100,000.)
  • Foolly on the other hand, had to do the calculations twice before he realized what a fool he had been. Foolly had lost down to $60,000. In order to make it back to $100,000, Foolly does his calculation and finds that he has to make 66.67%!! KYATMA outperformed him by 41.67%!!
  • Foolly grudgingly realizes that $60,000 x 66.67% = $40,000 which will get him back to his original $100,000.

Foolly Investor asked KYATMA Investor for some advice. KYATMA said, "Buy Rick's book!"