Have you ever heard the saying “losing money hurts more than making money helps”?
You’ve probably already understood that as you approach retirement you should begin
to take less risk with your money, but why? The reason is a math concept called
geometric mean that we will explore quickly (and painlessly). Before we get to
geometric mean, let’s start with something easy, average return.
If 8 years of your portfolio returns looks like this (-10%, +10%, -10%, +10%, -10%,
+10%, -10%, +10%) your average return is 0%. Like I promised, painless.
However, as soon as we add money to the equation and experience the same returns,
things change. If we start with a $2,000,000 investment portfolio and run the same set
of returns things change drastically. Your 2 million turns into less than $1,922,000 at the
end of the 8 year cycle.
How can that be?!
You just received an average return of 0% yet your real rate of return
over those 8 years was -3.9%. -3.9% is your geometric mean. Losing money hurts more
than making money helps.
You should know that bigger losses make those numbers worse!
Our same $2,000,000 portfolio down 40% year 1 and then up 40% year 2. Your average
return is again 0%, but that portfolio over those two years shrunk to $1,680,000. A
geometric mean of -16%.
If losing money really does hurt more than making money helps, having some of your
money protected from market losses should be a major priority as you approach
retirement.
