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Never Lose Money... and Why

July 28, 2013 | About:
You may have heard the quote by Warren Buffett, "Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1." We may say to ourselves, "Sure, of course that is true. Nobody ever likes to lose money." However, when that quote is fleshed out with actual numbers, you might be surprised with the findings and just how financially detrimental it can be to lose money.

Please view this graph I created below. The graph takes a look at the number of years it would take with a certain annual return to recover money lost. There are a few basic scenarios of 25% loss of investment and a 50%, 75% and 95% loss of investment. (I chose not to include 100% loss of investment because it would technically be impossible to recover any money from that.) The annual returns after loss range from 10% to 100%.

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An example of loss would be: If a person invested $1,000 in a stock and lost 25%, or $250, of that, how long would it take to recoup that $250 loss? If that person earned a 10% return in the years following the loss, it would take him 3 years to recover the $250 loss. If it was 50% loss, or $500, it would take him 7.3 years to recover it. A 75% loss, or $750, would take him 14.5 years and a 95% loss, or $950, would take him 31.4 years to recover the loss. It is interesting to note that the number of years it takes to get the money back doubles with each loss increment, meaning the higher the loss, the longer it takes to recoup.

Also note that this is a simple graph and does not factor in the time-value of money (the idea that money is worth less in the future), or opportunity cost. If we did factor in the time-value of money, just get your money back wouldn't retain your same purchasing power (assuming positive inflation). You would have to recover more than your original loss amount.

Losses can devastate any portfolio so you have to protect against loss first and foremost. As a wise man once said, "Focus on the downside, and the upside will take care of itself."

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