The Cruel Basic Mathethematics of Losses
An odd article in the today’s WSJ laments The Cruel Math of Big Losses.
What a terrible misonomer: This article should have been called “The Basic Mathematics of the Stock Market.”
Not understanding the simple percentages of losses and gains is a goodly part of the reason so many investors buy into the myth of Buy & Hold.
Consider:
“If an investment declines 10%, it takes about an 11% gain to break even (assuming you don’t pump in additional dollars). If the drop is 20%, you need a 25% gain to recover. A fall of one-third requires a rebound of 50%. And if your investment falls by half, “you need a double,” or a 100% return, says Mr. Wiener, the New York-based editor of the Independent Adviser for Vanguard Investors. The recovery percentages grow exponentially because you have so few dollars working for you after a big loss.
Last year, the average diversified U.S.-stock fund was down 37.5%—requiring a 60% advance to break even—and plenty of funds were down 50% or more.”
If you understand how this simple math works, then you are in a better situation to appreciate the importance of capital preservation.
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Source:
The Cruel Math of Big Losses
KAREN DAMATO
WSJ, NOVEMBER 2, 2009
http://online.wsj.com/article/SB10001424052748703399204574505713099802976.html
November 2nd, 2009 at 8:05 am
I always have a hard time explaining this to my clients!
November 2nd, 2009 at 8:44 am
That’s why people should invest in great big, brand new houses instead of stocks. Everybody knows, real estate never goes down (they’re not making any more of it, you know). Buy now, or be priced out forever.
November 2nd, 2009 at 8:47 am
That is why Japan has taken so long to recover.
November 2nd, 2009 at 8:49 am
I always ask people when their stocks are down and they refuse to sell, why don’t they buy more? They never quite get it. If your stock is down 20% and you want to ‘hold until it comes back’ then it is more rational to buy more at that level or sell it. The worst thing you can do is hold for a recovery because you are betraying your own confidence about the position.
If you really believed the stock was going to return to its old value then buying at the lower levels would show a profit on the whole lot when the shares got back to the original price. Instead of creating dead money while they wait a person should either buy more or sell because those trades are closer to their true inside opinion about the stock and successful trading involves properly harnessing your emotions in a trade. Not just your money
If you are working against your own psychology then you have lost your closest ally
November 2nd, 2009 at 8:57 am
I just had CNBC on for the first time in months, Kernan was waving the WSJ around lambasting an admin spokesman about a WSJ editorial and warning him not to fight the press, that ended my CNBC experiment.
Roberts from Comcast looks like a Dem based on his contribs. I don’t want the CNBC repub clowns replaced by Dem clowns but it would be nice to have some balanced reporting instead of a goulash of dem bashing and greenshoots cheerleading. Kudlow should be chained to the bumper of a pickup and drug around town a few times
November 2nd, 2009 at 8:58 am
common man-
but the old rule of advice- “never add to a losing position”- should clue them in to sell
November 2nd, 2009 at 9:05 am
This points out the problem with most introductory books on investing. The first chapter is never about risk management. If more traders started by learning risk management and trading just one index (SPY, IWM) well, I think a lot more people would be successful.
C&C
November 2nd, 2009 at 9:11 am
“An understanding of numbers plays an important part in our daily lives and even more so as our society advances technologically. No one expects to look out a window and to think about the numerical structure of what we see, just as we don’t picture the molecular structure of water as a boat floats by. Yet knowing how to use the mathematical tools at our disposal can help us function much more effectively and also enhance our critical thinking skills…”
http://www.innumeracy.com/numeracy.htm
~~
“”The superior man is distressed by his want of ability.” — Confucious
“I know of no more encouraging fact than the unquestionable ability of man to elevate his life by a conscious endeavor.” — Henry David Thoreau
I (Frederick Mann) have just upgraded from Eudora (an email program) 3.0 to 4.1 . The latest version provides significant improvements over the former. It automatically handles multiple e-mail addresses. One click retrieves e-mail for all of my addresses. While mail is being downloaded I can continue reading, writing, and sending messages. Downloading and filtering is considerably faster. Eudora 4.1 also includes other improvements.
There’s no limit to the improvements that can be made through upgrading computer hardware and software.
“All human beings, all persons who reach adulthood in the world today are programmed biocomputers. None of us can escape our own nature as programmable entities. Literally, each of us may be our programs, nothing more, nothing less.” — John C. Lilly
In similar ways to Eudora, we can upgrade our personal lives. To some extent we can upgrade our personal hardware through better diet, supplements, and exercise. We can remove old software (unlearning) and replace it with new, better software. We can add new software where there was nothing before. There’s no limit to the extent to which we can upgrade our personal software.
“In the province of the mind, what one believes to be true is true or becomes true, within certain limits to be found experientially and experimentally. These limits are further beliefs to be transcended. In the mind, there are no limits.” — John C. Lilly, Programming and Metaprogramming in the Human Biocomputer.
Most people suffer extensive downgrading during compulsory “education.” As a result of reading Robert Kiyosaki’s If You Want to be Rich and Happy, Don’t Go to School?, I recently discovered that this downgrading is in many cases much more severe than I had previously realized…”
http://www.buildfreedom.com/lists/upgrade.html
http://www.leapingfromthebox.com/hs/mathliterature.html
alternative, an Ignorant public is easier to Lie to..
November 2nd, 2009 at 9:32 am
In what has to be considered the most financial illiterate developed country in the world, does this really surprise anyone? For years now the literacy rate wrt finances has been falling. Now the boomers (while a whole lot better than the young) are headed out the equity door to protect their nest eggs, so we have the most illiterate young people in the history of the US coming in. This can not be equity positive other than through speculation. After all, the entitlement generation is owed a good retirement by virtue. http://www.mrrc.isr.umich.edu/publications/papers/pdf/WP191.pdf
November 2nd, 2009 at 9:43 am
“Mathe-the-matics”, “Mathy Thematics”
BR- a felicitous typo? I’d copyright it if’n I wuz yuh.
Hey Mark- I would add that an Ignorant public will buy what it shouldn’t [can't] buy:
http://www.mcclatchydc.com/227/story/77841.html
November 2nd, 2009 at 9:46 am
Crestmont Research apparently solved the problem of explaining basic math (and strategy) to clients by using pictures such as this at http://tinyurl.com/mwls6y
Simple message: “If losses are contained to 50% of the market drop, it takes only 64% of the gains to achieve market returns.”
Unfortunately simple messages are easy to forget when things get exciting and that may be the real duty of discipline: Remembering.
November 2nd, 2009 at 9:54 am
How is it that numbers are “cruel”? Indifferent perhaps, but cruel? There’s really no limit to how we anthropomorphise everything. Throw rocks at the temple all day long. The temple doesn’t care. It never cared.
This “cruelty” in numbers is why so many idiots really do think things are now doing well. 40-50% gain in stocks? 3.5% increase in GDP? With increases like that, although we aren’t even close to being back to even, gosh darn it, it just feels good.
November 2nd, 2009 at 10:13 am
chartsandcoffee,
“If more traders started by learning risk management and trading just one index (SPY, IWM) well, I think a lot more people would be successful.”
Not sure about that. After all, trading in the stock market is a Zero sum game. One’s gains are someone else’s losses. It would make the competition tougher. The gains would just be differently distributed. Perhaps, if a greater number was successful it would be at the expense of others who have smaller gains than they would have had otherwise, or others who have bigger losses than they would have had otherwise.
rc
November 2nd, 2009 at 10:15 am
@MEH — Eudora got as far as 7.1.0.9 — and then, having been acquired by Qualcomm, stopped being enhanced or supported in 2006. The final version required a (modest) upgrade fee — basically Qualcomm was milking the last bit of money they could out of their users. This final version has some unique, nasty bugs which of course were never fixed.
I’m not sure that Eudora turned out to be the best example of “no limit to the improvements that can be made through upgrading computer hardware and software.”
November 2nd, 2009 at 10:24 am
RC: “the stock market is a zero sum game.” Yeah if all you look at is stock ownership. But once you throw in swaps, derivatives, leverage, and nakedness (and other forms of “insurance” types) then the game is no longer a zero sum.
November 2nd, 2009 at 10:24 am
bergsten,
wake up~ that art. was written in ‘99 .. see BR’s recent post on ‘Context’, it may help..
past that, if you’re looking for a ‘new’ Hobby, “CogPsych” is a good option.
~~
MR,
no kidding~ as well, I, still, believe there’s an operative difference between (D) & (R), and the FedRes is US FedGov operation, as opposed to being a Private Bank –some things ‘grease the skids’, afterall..
November 2nd, 2009 at 10:26 am
@rootless…
There is no “zero-sum” game, unless markets/economies/etc. are contracting/shrinking. If there is growth, then everyone can win!
Now you know why “growth”, no matter what it’s type, whether illusionary due to monetary mischief, or due to unsustainable trade imbalances, or to unsustainable government borrowing, is the great god of America. Without growth, it is less than a zero-sum game, and it all comes falling down. So growth will always occur, in some form, illusory or not. When even the illusions fail, it all fails us.
November 2nd, 2009 at 10:27 am
@call me ahab November 2nd, 2009 at 8:58 am
but the old rule of advice- “never add to a losing position”- should clue them in to sell
But what is it that locks them in? It is their psychology. Everything in their heads is telling them to bail yet they can’t. If people could understand that by holding they are saying the price will go up but by not buying more they are negating that very thought, then maybe it would help them to get past the psychological block that freezes them in their trading tracks.
Another question I like to add to that is what is your time frame for this supposed break even? Then you really start messing with their heads. If they say a year then ask them if they would put money in the bank knowing that a year down the road they will have made no net return on investment.
If they honestly expect the stock to move from say $80 – $100 in a year’s time why aren’t they investing in an $80 stock if they think they can get a 25% ROI in that time? If they can’t justify going for the second stake they truly don’t believe what they are saying about the first stake. That is just their rationalization for holding a losing stock coming through
November 2nd, 2009 at 10:56 am
@MEH 10:24 — in 1999 Eudora may have (and I say “may have” because other computer architectures allowed you to multitask as far back as 1960 — IBM/AA’s Sabre for instance) served as a good example of potential never ending improvement. In the longer scheme of things it wasn’t, which was my point.
So, what’s your choice of “context” — a quotation (somewhat) accurate at a point in time, or with respect to how things actually turned out? DO footprints predict the future? Not in this case — TA’s please take note!
And here’s a hobby for you — computer history — http://en.wikipedia.org/wiki/Sabre_(computer_system)
Apologies for sounding snarky, guess I’m not “awake” yet.
November 2nd, 2009 at 11:10 am
rob,
“But once you throw in swaps, derivatives, leverage, and nakedness (and other forms of “insurance” types) then the game is no longer a zero sum.”
Why not? Whether in the stock market or with any other market instruments or tricks, the gains pocketed by the ones must be someone else’s loss. No wealth is being created in society just by selling stuff to each other in circles. The markets are just a big re-distribution-of-wealth machinery. At the end, those tax payers who haven’t even been part of the market game, but whose taxes are used to bail out failed market players may be the biggest suckers of all, though. Hey you suckers!
rc
November 2nd, 2009 at 11:12 am
@rootless_cosmopolitan November 2nd, 2009 at 10:13 am
Not sure about that. After all, trading in the stock market is a Zero sum game. One’s gains are someone else’s losses.
I hear that one thrown around a lot and that can be a myth if time is factored into the equation.
Let’s assume you have a 70 year old man who sells a $20 stock to an 18 year old kid. If the old person bought the stock 10 years ago for $1 and is now selling it to buy food for himself he has not lost anything. He has taken the growth that the company produced over the last 10 years.
If the kid is buying a viable, well managed company that he plans to hold for 10 years then he also has not lost any money in the transaction because he can trade his ability to wait over time for the old man’s need for cash over the short term.
Both are meeting their objectives and neither has lost anything assuming the company does not resemble much of what we see in the markets today.
November 2nd, 2009 at 11:13 am
bergsten,
no worries~ given ‘context’, from what I understood of dude’s article, he was saying, merely, that: ~” some programs are better than others, and, when reaching the, recognizable, limits of the, current, program–uninstall, and update with ‘better’ warez’..”
I hear ya, from the CompSci/Prog POV, though, somehow, I think that wasn’t were dude was coming from..IOW, while he may be think, wistfully, about the passing of Heathkit, I doubt he has digikey.com ‘bookmarked’ in his Opera browser..
November 2nd, 2009 at 11:25 am
Wow…! Let’s give Ms. Damato the Nobel Prize for Douche Baggery. How insightful and enlightening, all this from the same publication that qualifies every discussion on interest rates with a disclaimer stating that rates and prices move inversely. Noooooooo! really….?
Ciao,
Econolicious
November 2nd, 2009 at 12:19 pm
How the Common Man Sees It,
Your counter-example contradicts the statement that no one can make gains in the markets even when betting on the right company. I didn’t make such a statement. Your example only works, if you assume the successful company doesn’t dilute its shares to a degree that it will be the only real winner over the long-term at the end, anyway. Maybe the point you wanted to make with your counter-example is that there is long term growth of the economy and this should be reflected in the increase of the total value of all companies in the stock market. I don’t fully disagree with you here, but I was talking about trading as a tool to make gains, not about long-term investing. As for the long-term. How much does the US-economy grow by producing by much a year on average over the long-term? 3 – 4%? So, if you imagine all members of society as one single share-holder of the whole economy and the increase in the value of all goods in the economy is expressed as increase in the value of the shares, then the value of the shares should increase by about 3 – 4% a year on average. That’s it. This should also be the average increase in the stock market over the long-term purely due to economic growth. Thus, the best approach to achieve this may be to just hold shares of all companies in the economy and wait for 30 to 50 years or so (hoping there won’t be structural break-down of society during this period). But who wants to do that? Who participates in the markets as trader or investor for the promise of this small gain that only would probably realize over a very long time? Thus, subtracting this small long-term average gain due to economic growth from the big swings the markets show around this average not just over years, but also over decades, everything else is a Zero-sum gain.
rc
November 2nd, 2009 at 12:23 pm
It should say at the end
“.. everything else is a Zero-sum game.”
rc
November 2nd, 2009 at 1:27 pm
No doubt that buying at the low and selling at the high is a lot more profitable than buy and hold. But it is the only realistic approach for a lot of people who have a real dayjob. Figuring out when things are at a low or a high is extremely difficult, even for those that have it as their full time job. Most of those who try to time the market end up buying high and selling low (losing money to the big guys). Unless you can do it full time, I think most people will do better with buy and hold on a diversified portfolio, combined with a little bit of rotation in emphasis on specific sectors, and regular rebalancing.
November 2nd, 2009 at 1:46 pm
@r
As for the long-term. How much does the US-economy grow by producing by much a year on average over the long-term? 3 – 4%? So, if you imagine all members of society as one single share-holder of the whole economy and the increase in the value of all goods in the economy is expressed as increase in the value of the shares, then the value of the shares should increase by about 3 – 4% a year on average. That’s it. This should also be the average increase in the stock market over the long-term purely due to economic growth.
Keep in mind this is all theoretical and does not necessarily reflect the ‘real’ world:
Society at large not only reflects the winners but also the losers. The stock market, in general, does as well. That being said it is possible to pick a company that produces goods over time that is able to outperform the economy via innovation and productivity enhancements for the short to medium term. I don’t think the time span would be much beyond say 10 – 20 years because at some point, as some say, the company would become the economy due to compound growth
So as far as the company can innovate and improve economic conditions within an economy, finding ways to benefit from the good and avoiding the bad, I think they can grow above the average. Especially if you were to catch the best of growth in your early years and then just matched economic growth later. They can also move outside of a single economy and become a multinational. Thus benefiting and possibly revolutionizing other economies before the restraints of size catch up to them.
I’m not saying it is probable to find a company like that but it certainly is possible
Thus, subtracting this small long-term average gain due to economic growth from the big swings the markets show around this average not just over years, but also over decades, everything else is a Zero-sum gain.
Well, championships are won at the margins.
November 2nd, 2009 at 2:27 pm
DeDude,
“Unless you can do it full time, I think most people will do better with buy and hold on a diversified portfolio, combined with a little bit of rotation in emphasis on specific sectors, and regular rebalancing.”
Unless it doesn’t work. Like in the US-market for the last 10 years or in Japan for even 20 years. But maybe buy-and-hold investors have still done better as the ones who tried to time the market and ended up buying high and selling low.
However, who is willing to wait for 30 – 40 years to prove the buy-and-hold strategy to be the right choice over the long term? I am not.
rc
November 2nd, 2009 at 3:27 pm
While we’re on the topics of innumeracy and growth, let’s throw in the fact that not enough people understand the exponential function. See http://www.chrismartenson.com/martensonreport/exponential-money-finite-world.
November 2nd, 2009 at 3:57 pm
Can’t remember where I saw the chart, but if you adjust the DJIA for inflation since 1920’s it’s gains become pitifully small.
Curmudgeon nailed it, as long as there is growth in the equity indices, the stock market is not a zero sum gain. On the other hand, all derivatives are definitely a zero sum game since two parties are always taking opposite sides of the bet and the instrument is not perpetual.
November 2nd, 2009 at 6:33 pm
“As long as there is growth”. How can there always be growth? Things run out.
Oops, wrong link in my above comment (and no way to edit it). Try this: http://www.chrismartenson.com/blog/exponential-money-finite-world/29744. I just discovered this guy today, and am finding him quite compelling.