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Friday, 25 September 2009

Bringing Your Portfolio Back to Even

by Douglas Rice
Thursday, September 24, 2009

Even the recent gains in the stock market haven't made a dent in many portfolios, leaving many investors wishing for the good old days of 2007. After all, it's only natural to want to get back to a point of profitability.

Most investors have muttered to themselves at one point or another: "I just want to get back to even." This is a poor strategy as it mandates a return to the past in the same strategy that got you to the bottom. If it's just one stock, a shock could lead to a rebound, but if it's the entire sector trying to regain past glory, it's likely that the strategy that took you down will not be a good strategy to get you back to even.

The Numbers

Many investors make an assumption about the amount of return that they need to get back to even. They might quickly do the math in their heads, and that can lead to major mistakes. For example, the common assumption that an equal percentage gain will offset the same percentage loss shows a significant shortfall.

For example, if a portfolio falls 50%, then gains back 50%, the portfolio isn't back to even; when $100 falls 50%, it equals $50, and a 50% increase in $50 is $75. So, while the portfolio went up and down the same percentage amount, the result is a 25% loss.

From a 50% loss, the math to get back to even requires a 100% return. This is not exactly what most people think or what they want to hear. If this is spread out over several years and eventually the portfolio gets back to even, the opportunity cost is tremendous as the time value of money has been lost, never to be recovered.

Remember, it takes at least twice as much return to get back that initial loss.

Economy Matters

Even though stocks have a mind of their own, the overall economy still matters. Sure, stocks can race ahead of booms and collapse in front of recessions, but the economic conditions are still the bedrock for the overall situation. Currently, we may be moving out of a recession, but no one is predicting stellar growth.

If we look at that in context of getting back to even, then stellar growth is paramount to getting back to market highs. Until we boom again, there isn't any fundamental reason to push stocks prices back to their previous lofty levels.

One other concern is inflation. While not typical, there is an economic condition where inflation rises but stock prices don't. In that case, not only will the portfolio not get back to even on a nominal basis, but on an inflation-adjusted basis the portfolio will be still be losing ground even when stocks rise.

For example, if a portfolio rises 5% and inflation hits 6%, then the gains are welcome, but the purchasing power of those gains shows a loss. If this continues for any length of time, getting back to even on an inflation-adjusted basis could prove to be very difficult.

Vary Your Investing Techniques

If this wasn't enough, there is one more big piece of bad news: The is no guarantee that a portfolio will ever get back to even. Those that invested in boom firms may have invested in the horse and buggy just before cars became the norm.

For example, the dotcom boom-bust took the Nasdaq index up to over twice as high as it is now, and that was almost years ago.

So, the strategy of holding on and thinking it will come back wouldn't have worked very well in that index, not to mention with a portfolio of dot-com stocks. And there is no reason for that index, or those stocks, to get back to all time highs any time soon.

We find another example if we look to Japan's boom and bust; the Nikkei was at 40,000 in 1990 and today, more than 20 years later, it's less than a quarter of that. Does anyone really think the Nikkei is going back to 40,000 anytime soon? Buy and hold in that market has provided nothing but misery over two decades. When will we go back to the froth of the mid-2000s? No one really knows, but it's possible it's not anytime soon.

Summary

If you are thinking that you just want to get back to even, then make sure you understand how much return you are going to need, consider how robust the economy is going to have to be to get that return, and then update your investment choices in the portfolio to reflect the new situation. It's important to avoid blindly thinking that the same strategy that took you down will take you back up.

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