Market ups and downs - and why they matter

As I type, the S&P 500 index is officially in positive territory year-to-date. Most people are very excited about this. So am I. It is good news! But today I want to dig a little deeper with you and take a closer look at how periods like the last couple of months can impact long-term investment returns.

Most of us understand that investment markets will go up and they will go down. We call this up and down movement “volatility.” Too much volatility can make investing hard for some people to stomach. But totally removing all volatility comes with a price: it becomes more difficult to generate much in the form of returns on our investments. (A CD at the bank might have no volatility, but its paltry return can't even keep up with inflation.)

So we accept the premise that we will endure some amount of volatility as investors. The question begs: how much volatility? That question is answered individually based on your risk tolerance, goals, and time horizon.

But how should we think about volatility and our investments? Many financial advisors live by the mantra that “we must participate in the short-term downside of the market in order to achieve the long-term upside.” This is true, to a degree. But let’s dig deeper: how does volatility impact returns? What exactly does it do to our long-term goals when our investments take a significant short-term hit?

To help answer that question, I’d like to pose a quick question to you today that I have been having a lot of conversations about lately. I will give you two people. You tell me who has more money after two years.

Person A: $1,000,000 invested.

Year 1 return: +10%.

Year 2 return: +10%.

Person B: $1,000,000 invested.

Year 1 return: -20%.

Year 2 return: +40%.

What does your gut reaction tell you? Who is ahead after two years?

I’ve done this exercise with twenty different people in the past month. Lawyers, extremely successful business owners, pro athletes... Almost everyone has the initial reaction that Person B is ahead after the two years. That juicy 40% return sounds good doesn’t it?! But the truth is, Person A is ahead. Person A ends up with a little over $1,200,000. Person B has $1,120,000. Math is wild, isn’t it? The preservation of capital is a very important tenet of investment success. Perhaps this is why Warren Buffett's #1 rule is "Don't lose money."

Said another way, it takes a 100% gain to make up for a 50% loss. Yes, you read that correctly. If you have $10 and it goes down 50%, you now have $5. At this point you need another $5 (a 100% return) to get back to your original $10.

This exercise is a great reminder that while we know some amount of volatility is a requirement of investing, too much of it can be a real drag on investment returns. There is real power in managing volatility when, where, and how we can as we construct and manage your investment portfolios. It is a focus of my investment strategy.

Big returns might get the headlines, but risk management drives long-term investment performance.

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Choosing wealth vs. chasing riches

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Intra-year volatility plus a market update