The cruel math of investment losses.
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By David Kathman, CFA | 03-10-09 | 06:00 AM | Email Article

The terrible market declines of the past year have investors everywhere licking their wounds and toting up their losses, even as they prepare for the possibility of more losses to come. Nearly every portfolio that holds stocks is down significantly since late 2007, with 40% declines not uncommon. Just about the only solace is the thought that the market is bound to turn around at some point, and then people can start making up some of the ground they've lost.

David Kathman, CFA, is a senior mutual fund analyst with Morningstar.

But what, exactly, will it take to make up those losses? Many people underestimate the gains needed to recover from big investment losses, and the extent to which additional losses put you deeper in the hole. Amid all the current market gloom, it's worth taking some time to understand what it might take to recover from the current market swoon.

Climbing Out of the Hole
Suppose you hold a stock that falls 50% in value. How much does that stock have to gain before you're back where you started? Many people instinctively say 50%, but that's wrong. If the stock's price starts at $10 and loses 50%, it's at $5; from there, gaining 50% would put it only back up to $7.50. To get back to $10, the stock would have to gain 100%, twice as much as it lost in percentage terms.

Recouping losses always requires a larger percentage gain than the loss itself, and the difference between the two gets more dramatic as the losses get larger. For example, as of March 5, Tivo  stock had lost 10.1% over the past year, meaning it will have to gain 11.2% to recoup that loss. As of the same date, homebuilder  Toll Brothers  had lost 30% over the past year, but it will have to gain 43% to get back to where it was a year ago.  Starbucks  had lost 51%, and it will need to gain 103% to make up those losses.

Once the losses exceed 50%, as they have for many financial stocks, the numbers get even uglier. For example, regional bank  KeyCorp  has lost 68% of its value over the past year as of March 5, meaning it would need to more than triple in price (gaining 214%) in order to make up for that loss. (If KeyCorp gained 68% from this point, shareholders would still be down 46% overall.) The numerous stocks that have lost 80% or more over the past year--nearly 900 of which are traded on the New York Stock Exchange or on Nasdaq--are in much worse shape and are unlikely to get back to where they were in the foreseeable future.

Easing the Pain
All this may seem a bit depressing, and it is, but it highlights the importance of diversification. If you had your entire life's savings invested in one of the stocks that have completely imploded, your portfolio would be critically damaged and would be facing a long recovery. But, of course, very few investors have all their money tied up in a single stock, and with good reason; as we've pointed out many times before, diversifying your holdings helps stabilize a portfolio and lessens the chance of one investment torpedoing returns. Even in a market where everything is down, like last year, moderating your losses can make it much easier to bounce back.

The best way of diversifying a stock portfolio is through asset-class diversification. While major stock indexes all lost more than 30% in 2008, the Barclays Capital (formerly Lehman Brothers) Aggregate Bond Index gained 5%. Of course, many individual bonds and bond funds declined in value last year, but the magnitude of those losses was generally much less than for stocks. A portfolio consisting entirely of  Vanguard 500 Index  would have lost 37% in 2008, and would need to gain almost 59% to regain that lost ground. Putting 20% of the portfolio in  Vanguard Total Bond Market Index  would have reduced that loss to 29%, and the percentage needed to make it up would be reduced to 41%. Putting 40% in the bond fund would reduce the portfolio's loss to 20%, which requires only a 25% gain to make up. Losing 20% or 30% in a year is certainly not fun, but it's a lot better than losing 40%, 50%, or 60%, as these figures illustrate so well.

One very basic rule of thumb for determining a good stock-bond allocation is to subtract your age from 100, which gives a rough estimate of the percentage you should have in stocks. Thus, if you're 50 years old, it's a good idea to have 50% of your portfolio in stocks; if you're 60, it makes sense to have 40% in stocks; and so on. Alternatively, tools like Morningstar's  Asset Allocator (available to Premium members) can help you arrive at a customized stock/bond split.

In addition to making sure your portfolio is diversified by asset class, it's also important to ensure that its spread across different industries and individual securities. A simple way to get broad stock exposure is through an index fund such as  Vanguard Total Stock Market Index , which tracks the Dow Jones Wilshire 5000 Index, or Vanguard 500 Index, which tracks the S&P 500 benchmark. Vanguard 500 Index lost 37% in 2008, which was certainly painful, but not nearly as bad as many individual stocks performed. And such losses are very rare for broad market indexes like this one; only once since 1926 has the total return of the S&P 500 (or its predecessor the S&P 90) been lower than it was in 2008. (That was in 1931, when the index lost 43%.) On the other hand, the S&P 500 has gained at least 37% in eight different years since 1926, twice gaining more than 50% (in 1933 and 1954).

While there's certainly no guarantee that the market will go on a tear like that any time soon, the potential for sharp upward gains--or perhaps better yet, slow and steady gains over a period of several years--makes it possible that long-term stock investors will not only be able to make up their recent losses but will outpace conservative investments like cash and bonds over time.

 

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David Kathman, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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