The Five Secrets to High Performance Investing – Secret 3

In the last video we demonstrated how a low-risk investment portfolio can generate significantly more wealth for an investor, despite holding investments that generate lower average simple returns. In this video, we are going to show you the secret behind why risk has such an out sized impact on your investing outcomes. The third investing secret is that compounding losses are devastating to your wealth. When we ask people why they invest their money in the markets, a common response is that they want to take advantage of the powers of compounding. People often say, I want my money to work for me, meaning they want their wealth to grow using the powers of compounding. Einstein once called compounding the 8th wonder of the world, I would venture to guess that his thoughts on compounding were more nuanced than this simple quote would lead most to believe. What is key to understand about the power of compounding is that compounding cuts in both directions, positive returns compound and losses compound as well. Unfortunately for investors, compounding losses are a wealth destroyer and loom over an investment portfolio like the death star. Risky portfolios generate higher average losses with greater frequency than low-risk portfolios. Because losses compound just like returns compound, more frequent and larger losses means the impact of compounding slows down the accumulation of wealth. That is a big problem few investors think about. But there is more! because of the math behind how compounding works, larger losses have a disproportional impact on the wealth an investment portfolio can accumulate. The problem compounded losses present, is that the relationship behind the size of the losses your portfolio incurs at any point in time and the returns required for your portfolio to recover from those losses is exponential! The next chart I am going to show you illustrates the exponential relationship between the size of the investment loss and the returns required to recover from the loss. If your portfolio accumulates a loss in bad markets of -20 percent, you do not have to generate returns of 20 percent to get back to even, you must generate returns of 25 percent to recover from your losses. However, if your portfolio accumulates a loss of 50%, which happened to many investors in 2009, then you must generate returns of 100 percent to get back to even. God forbid your portfolio should generate losses of 70 percent as that would require returns of 233 percent to recover from.  What I hope is clear from this chart, is that the larger the loss your portfolio suffers, the exponentially higher your returns must be to recover from your losses and get your portfolio back to even. In other words, large losses have a permanent impact on how much wealth you can accumulate because of the opportunity cost of using larger and larger amounts of your positive returns to recover from your most recent losses. What is also important to mention is that the riskier your portfolio is the more volatile your daily price movement will be. High volatility in your daily average portfolio value is very inefficient for wealth accumulation because despite the losses being small, you must always earn more than you lost to get your portfolio back to even. So while large losses are devastating to your wealth, small frequent losses will drag down the potential of your portfolio to accumulate wealth efficiently. Low-risk portfolios are more efficient at steadily accumulating wealth because over the long-term they have less volatility in the portfolio value and therefore compound higher average portfolio values over the long-term. This works the same as a bank account with a higher average balance, because of the higher average balance you earn more interest than a bank account with a lower average balance. Low-risk portfolios can dominate high-risk portfolios in terms of the wealth they can accumulate for investors because they use less of their positive returns to recover from the smaller losses the portfolios tend to generate. Low-risk portfolios dig shallower performance holes, which means they do not need to produce as high of returns to recover from the most recent loss. This is why we always say risk is inefficient, by limiting risk you can generate higher compounded returns more efficiently. We can see efficient wealth accumulation in action when we look back at the chart that shows the growth of $100 invested in both the high and low risk portfolios. You can see the low-risk portfolio has a smoother and steeper growth line with consistently shallower dips. Risk efficiency is why the low risk portfolio gradually, over the long-term crawls further and further ahead of the high-risk portfolio, in terms of wealth accumulation. And when the stock market suffers large losses, like during the recession in 2008 and 2009, the low-risk portfolio generated much smaller losses which moved the portfolio far ahead of the high-risk portfolio in terms of wealth accumulation because of the disproportional impact that large losses have on your wealth. When a big recession hits, low-risk portfolios can gain an advantage over high-risk portfolios that a high-risk portfolio may never catch up from. This is why large losses can have a permanent impact on your wealth and another reason why lowering your investment portfolio risk is so important. After all, almost all investors will be invested during at least one recession. In this video we have shown you that compounding works in both directions and that lowering risk in a portfolio results in more efficient wealth accumulation. We have also showed you why large losses have a disproportional impact on your wealth and should be avoided as much as possible, that is if your investment objective is to maximize your wealth from investing. The key point I want you to take away from this discussion is the following: : Compounding losses are devastating to your wealth because of the exponential relationship between the size of a loss a portfolio sustains, and the returns required to recover from those losses. Additionally, the high volatility in the portfolio value caused by risk also eats away more gradually, but materially at the amount of wealth your portfolio will accumulate for you over the long-term.