When it comes to markets and investments, it’s easy to focus on the upside. Lists of the top-performing sectors, funds and individual stocks feature prominently in financial media each year. It’s fun to focus on winners. Much less attention is paid to the equally important elements of volatility and downside risk.
Volatile periods can be unnerving for investors. They can result in emotional distress and may lead investors to succumb to decision-reversal risk, potentially abandoning their chosen investment program at precisely the wrong time — that is, at the point of maximum loss. But losses hurt mathematically as well as psychologically: They can have a serious negative effect on an investment’s long-term growth due to an effect known as “volatility drag.”
Consider a hypothetical $100,000 investment that loses 20%. To recoup the loss, the investment must gain 25%. Deepen the loss to 50%, and the gain to recoup the loss grows to 100%. The rebound gain necessary to recoup losses grows exponentially from there, as illustrated below.
Breaking even can be hard to do
The outcome of this mathematical relationship is that even if an investment falls by 5% and subsequently rebounds by 5%, it ends with a loss of 0.25%.
Given its impact on the long-term growth of wealth and potential ramifications on behavioral elements, investors should be mindful of portfolio or investment volatility and downside resilience measures, not just returns data. They may find that downside resilience isn’t just nice to have — it’s practically a must-have for long-term wealth creation.
When comparing investment alternatives, consider a few important metrics beyond absolute results:
In the paper linked below, we take a closer look at how the thoughtful approach to risk mitigation taken in the American Funds Target Date Retirement Series® has delivered favorable outcomes for participants.
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