Limiting Losses Increases Your Gains

Downside protection can be more important than upside gains. Learn why it’s difficult to come back from steep market declines.

Renowned investor Warren Buffet has said there are two rules to investing: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.” Of course, there are times when your investments will lose value, and cashing out at that time will guarantee a loss. Not only is it important to stay invested in order to take advantage of the market’s upturn, it’s also key to try to limit the severity of those drops.

Indeed, minimizing losses could actually be more important than maximizing gains. Doing the investment math shows that a loss hurts more than a comparable gain helps.

Consider the following example: If a $1,000 investment loses 50%, its value drops to $500. In order for the investment to return to the $1,000 level, that $500 must do more than gain 50% (which would bring it to only $750); it needs to double. The deeper the hole, the harder it is to climb out of it, as shown in the chart below.

In recent memory, the Dow Jones Industrial Average dropped by more than half (53.8%) between October 9, 2007, and March 9, 2009. It took a gain of 117% over four years for it to recover its value (on March 5, 2013). Investors who lost less during that downturn would have recovered sooner.

Market declines are a regular occurrence. In fact, the Dow Jones Industrial Average has dipped 10% or more an average of once a year. These downturns remind us of the importance of making downside protection a criterion when selecting investments. Mutual funds that have a history of losing less during downturns don’t need to gain as much during upswings in order to potentially outpace their peers over longer time frames.

A well-diversified portfolio can help reduce volatility and build wealth. With patience, discipline and time, long-term investors can generally withstand shorter term declines and move closer toward their financial goals.