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Arithmetical Losses

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Older readers may remember a time when loss referred to Joe Loss and his Big Band Orchestra. Nowadays, of course, loss is more synonymous with debt and deprivation. The mathematics of loss are easy enough to outline but are notoriously difficult for consumers to imagine. If one suffers a 50% loss – it takes a 100% gain to get back to breakeven – this reality is beyond most consumers. And suggesting that it takes a 300% gain to recoup a 75% loss is met with utter incredulity. But it is arithmetically true! Losses can be financially deceptive.

Due to the behaviour of mean reversions (covered in a February 2017 blog) the performance of stock markets do tend to ebb and flow over time. It is estimated that over a 100-year timeframe the Dow Jones Industrial Average has spent 75% of the time declining in value (or recovering from earlier losses) and only about 25% of the time standing still or reaching new highs. MMPI has argued that mean reversion is an enhancing behaviour that allows stock markets to reflect fair and reasonable value over time.

Based on these statistics it is obvious that investors, who take an active interest in what’s going on, spend 75% of their time analysing downward movements and partial recoveries up to previous heights. It is no wonder, therefore, that many become disillusioned – 25% of the time observing real growth just isn’t enough to counter their dubiousness – which is unfortunate.

More seasoned investors recognise that longer timelines are necessary to achieve sustainable growth. We accept that sometimes a quick spurt in valuations can result in sudden win-falls but such movements are not easy to spot and the gains are usually not maintained in the longer term.

For those who have the time to spend studying valuations, tactical adaptations are often the most rewarding – for others the “invest and hold” philosophy is the best approach. In consideration that markets tend to rise over time, consumers saving for a pension, for instance, are far better leaving their funds invested for 20-30 years – rather than worrying about newspaper headlines that concentrate on dramatic short-term movements.

And yet irrational optimists abound!! Not wearing a seatbelt is irrationally optimistic. Believing that you can pick the lotto numbers is irrationally optimistic. Acting on a share tip and expecting to win a fortune is irrationally optimistic. Irrational optimists spend most of their time chasing losses that are beyond the realms of their optimism.

Mathematicians talk about loss of significance to demonstrate undesirable answers to their quadratic equations. A loss of significance to a consumer is any amount of money that they cannot afford to lose. On that basis, following attractive short-term movements in share prices is not recommended. Arithmetic loss will occur and you will spend an inordinate amount of time worrying unnecessarily. Active and passive investment options are real strategies that have their own merits. However, active decision-making is best left to professionals. Consumers should adopt longer-term hold disciplines and enjoy life.

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