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The Steep Road to Recovery

If you’ve experienced a drop in your retirement account values of the past 2-3 years, you’re not alone.  Unfortunately, millions of Americans weren’t adequately prepared for the events of 2008, and many saw losses to their retirement accounts in excess of 30-35%, representing billions of dollars nationwide.

A common question we often field from new clients looking to recover from losses is, “What do I need in order to bounce back?”

One of the more compelling aspects of investing is the math of gains and losses. Simply put, a 50% gain does not allow a portfolio to recover from a 50% loss. In fact, a 100% gain is required to restore a 50% loss. (The figure below illustrates the gain necessary to recover from a variety of different percentage losses.)

Figure 1: Recovering from a Portfolio Loss

As shown in Figure 2, there is a nonlinear relationship between losses and the required subsequent gain needed to recover from the loss. The term “nonlinear” simply means that as the loss gets bigger, the gain needed to restore the loss increases at an increasing rate.

Figure 2: The Steep Road to Recovery

(This is a hypothetical example and is for informational purposes only.)

For example, a loss of 35% requires a 54% gain to restore the portfolio to whole. That said, how long might it take the S&P 500 to generate a 54% gain? Obviously, no one knows that answer, but let’s just look at the past four decades for an indicator. From 1970 through 2010, the S&P 500 Index never had a one-year return in excess of 54%.
1 Thus, while you can lose 35% in a year’s time, the likelihood of making up that loss in an equivalent time frame is slim to none.

Smaller losses, such as a 20% loss, may be more quickly resolved. The S&P 500 Index generated a single-year gain of 25% or more (25% being the minimum gain needed to restore a portfolio following a loss of 20%) in 10 separate years between 1970 and 2009. 1More serious losses require longer recovery time frames, if recovery is even possible at all given your specific retirement horizon.

This brings us back to what many consider Rule #1 of Investing: Avoid losses wherever possible.  Whether you’re looking for continued conservative accumulation for retirement or you’re ready to convert the savings you’ve built into income you can rely on, the quickest way to derail your strategy is to incur losses from which you can’t recover.

1 May 2, 2011.
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