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By Noah Solomon
Special to the Financial Independence Hub
Many investment professionals tell their clients:
- That markets tend to rise over the long-term.
- To “hang in there” and “sit tight” during bear markets because they will eventually recover their losses.
While we agree with the first assertion, we wholeheartedly disagree that investors should sit idly through bear markets based on the notion that they will eventually live to see a better day. Rather, we strongly believe that a dynamic approach that adjusts to changing markets can provide superior long-term results.
The table below illustrates this by showing what happens to $1M invested in two different portfolios:
| Portfolio A | Portfolio B | |
| Year 1 | -30% | -5% |
| Year 2 | +30% | +5% |
| Year 3 | -30% | -5% |
| Year 4 | +30% | +5% |
| Sum of returns | 0% | 0% |
| Value at end of year 4 | $828,100 | $995,006 |
Since the returns over four years add up to 0% for both portfolios, many people assume that the final value of each portfolio at the end of year 4 should be $1 million. However, as the last line in the table indicates, this is far from true.
Portfolio A, which is more volatile, declines in value by $171,900, while portfolio B, which is less volatile, suffers a decline of only $4,994.
The observation that two portfolios can have the same sum of returns over 4 years yet have significantly different values at the end of the period can be explained by the mechanics of compounding. After experiencing a 30% loss, a $1 million portfolio is worth only $700,000. Unfortunately, a subsequent 30% gain will only bring the value of the portfolio back to $910,000, which is still $90,000 less that its starting value. However, when a $1 million portfolio experiences a 5% loss, its value is $950,000, and a subsequent gain of 5% will bring its value up to $997,500, which is only $2,500 less than its starting point. Continue Reading…
