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I saw someone post this image on LinkedIn this week.
Their commentary on the image is:
You want to risk-manage your hard-earned assets.
Here are some rough estimates on the return you would need (in right) to break even again (regain) after taking a loss (on left). Returning to break-even isn’t a 1-for-1 process.
Risk management is key.
You might have seen something similar before. I know I have. Lots of investment people out there talk about how small percentage declines require big percentage gains to get back to even.
The arithmetic itself is 100% correct. But I ask, “So what? What’s the takeaway?”
Their takeaway concerns volatility and risk management. They’re claiming that losses are “extra” harmful because they require larger subsequent gains to get back to even. As this particular investor wrote:
“Returning to break-even isn’t a 1-for-1 process.”
In other words, “Be extra fearful of losses, because they count ‘more’ than gains.”
This is flawed logic. We need to stop this line of reasoning. It doesn’t make sense.
Forgot My Keys…
Imagine I’m walking to the office. It’s about a mile each way. I get within sight of my office building and reach for my keys…oh sh**, I left my keys at home.
I call home, ask my wife to grab them for me, and she meets me part-way. But still…I need to walk 75% of the way back home to meet her. My progress dropped (-75%). I grab the keys from her (~~thank you!!~~) and turn around toward work.
How do I get back to where I was before? I would now need more than +300% progress to get back to the office.
WOW! 300%! That’s a lot!
You might think that my walk back to the office would be ~4x harder than the walk home. After all, 300% is 4x as much as 75%. It might not appear to be a “1-for-1 process.”
But we all know how to walk down a sidewalk. We can picture going back and forth three-quarters of a mile. It’s the same distance each way! It is a 1-for-1 process, no matter what the percentages say.
When a stock (or the stock market as a whole) has to “go back home” down its own economic pathway, it can just as easily go back up. There is nothing “harder” or “easier” about one direction over the other.
The Stocks Don’t Know
Stocks don’t know their own price.
Stocks don’t know who owns them.
Stocks don’t know about percentages.
Most of all, stocks have no idea “where on the sidewalk” they are right now. And investors shouldn’t care either. If a company’s new earnings report justifies that it’s now worth an additional $10 per share, then its new price should reflect that. It shouldn’t matter whether it’s going up $10 from an old price of $50 (a +20% jump) or $500 (a +2% jump).
Stocks and stock prices simply respond to the economic supply and demand that investors like us place on them. The supply and demand are measured in dollars. Not percentages.
A decrease of $100 is equal-but-opposite to an increase of $100. However those two are measured in percentages is an afterthought.
If stock gains were “harder” than stock losses, it would beg the question: why? What is the underlying mechanism that makes gains harder than losses?
(In fact, if you really want to make an argument about the “difficulty” of gains vs. losses over time, I think it would be that gains appear easier to achieve than losses. But that’s not the point I want to make today.)
The stocks don’t know. The prices respond to supply and demand. Percentages up and percentages down aren’t “easy” or “hard.”
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