Chasing a strong market is a lot like skiing a risky slope. The journey is thrilling, but perilous. Market highs often tempt investors to chase momentum, which sets them up for a dangerous fall. A less hazardous run is wisest for the long pull: Staying put and sticking to your risk level at all times.
On a recent trip to Park City, Utah, I ventured over to the most intimidating ski terrain I have ever encountered – the Snowbird Resort. The mountain is littered with steep grades and cliffs, exposed rock, narrow cat tracks and very high ski lifts.
If you take any of the lifts to the peak of the hill, you can see very little in any direction except the edge of the narrow ridge you are standing on and other mountains off in the distance. There is – quite literally – nowhere to go but down, and fast.
For some, this produces a desire to retreat. The safest way down from the top of the mountain is to hop back on the aerial tram and ride it to the bottom. You are technically safe, but you miss the point of being there in the first place.
For others, the adrenaline rush is addicting. The opportunity to test their skill, courage and, yes, luck offers a heady excitement. Each time they make it down safely, they begin to forget about all the rocks and cliffs they passed on the way up. Their past success breeds confidence.
As U.S. markets linger near all-time highs, many investors feel like they are standing at the peak of Snowbird. Like the skier who laughs off the risks, investors who stretch too far expose themselves to potentially devastating results.
For example, two investors go through a market rise and subsequent market decline. Investor A has a diversified portfolio that earns 10% during the rise, then loses 10% when it drops. Investor B has a concentrated stock portfolio that earns 50%, then falls 50%.
When the market climbs, investor B is praised as a genius at cocktail parties. Everyone wants his advice, and he can’t talk about his investing prowess enough. Investor A, meanwhile, is overlooked as being a conservative, vanilla investor.
To the untrained eye, the simple average return for those two periods is identical. What really happens is that big negatives hurt performance far more than the equivalent upside.
If each portfolio is worth $100, investor B gains $50 first, or $150 in total. A subsequent 50% market dip then leaves him with $75, or a loss of 25%. Investor B, on the other hand, gains a modest $10. Her subsequent 10% loss leaves her with $99, or a loss of 1%.
| Gain | Loss | Simple Average | Actual Return |
A | +10% | -10% | 0% | -1% |
B | +50% | -50% | 0% | -25% |
When you hear about the mathematics of compound interest, it’s almost universally in a positive context. The more important discussion, however, is the impact of losses. A 10% loss requires an 11% return to break even, a 20% loss requires a 25% gain, and a 50% loss requires a 100% rebound. Skiing off a cliff just once can erase all the gains you make.
Everyone wants portfolio B when markets rise and portfolio A when markets decline. We all know that consistently achieving that result is nearly impossible in the investment world, yet many people can’t help themselves from trying.
Stretching for yield during times of low interest rates, abandoning underperforming asset classes, or making guesses about what lies ahead are sure ways to increase the potential for a large loss. Conversely, investors who seek shelter miss out on future gains.
Stay in your comfort zone and remain committed to the level of risk appropriate for your personal goals. Diversified portfolios recently lagged U.S. stock indexes, but they still provide a nice blend of growth and stability for a very enjoyable ride.
Follow AdviceIQ on Twitter at @adviceiq.
Joe Pitzl, CFP, is the managing partner at Pitzl Financial in Arden Hills, Minn., and also writes at Financial Fairway. Follow Joe on Twitter at @joepitzl. Learn more at www.pitzlfinancial.com.
AdviceIQ delivers quality personal finance articles by both financial advisors and AdviceIQ editors. It ranks advisors in your area by specialty, including small businesses, doctors and clients of modest means, for example. Those with the biggest number of clients in a given specialty rank the highest. AdviceIQ also vets ranked advisors so only those with pristine regulatory histories can participate. AdviceIQ was launched Jan. 9, 2012, by veteran Wall Street executives, editors and technologists. Right now, investors may see many advisor rankings, although in some areas only a few are ranked. Check back often as thousands of advisors are undergoing AdviceIQ screening. New advisors appear in rankings daily.