A Beginner Explanation to Downside Risk (Losses)

Downside Risk Stratosphere

The Mantra of Investing

You have heard it a million times.  High Risk = High Reward.  What if I was to tell you that this statement could not be more wrong.  Let me explain the facts with good ol' mathematics.

Returns Required to Recover Losses

This figure below illustrates the required returns to break even on a loss from a particular position.  As you can tell, the math is not in your favour and the larger the loss, the more it exponentially hurts your portfolio.  Not pictured, if you have a -75% return, you require a +300% gain to break even due to this exponential phenomenon.  Let me tell you - watching equity markets companies operating with high debt to equity ratios over the years, it is a lot easier to see a company's share price plummet very quickly of -75% than shoot up +300% in a short time span.

Required Gain To Break Even

Annual Returns and Downside Risk

It is important that prudent investors operate with a margin of safety and minimize downside risk. Losing principal will diminish returns and require significant upside to recover. I cannot stress this importance.

I will explain why with numbers how downside risk works:
If you were to make an 100% return this year on $10,000 = $20,000 If you were to now lose 50% next year on the now $20,000 = $10,000

Your average return over 2 years? 50% Woah! But, not so fast, you still have 10K. What this means is that proper valuation is important. You would not pay a steep price for Joe's Hot Dogs across the street if Joe didn't turn a profit. Why would you in the stock market?

Microsoft Case Study - Dot Com Bubble

Analyzing Microsoft, ticker MSFT, we see a company with an extremely competitive advantage. However, if you bought the stock in the height of the tech bubble in 2000, you would have a negative return until November 2016. How could that be? A company like MSFT had a negative return for 16 years? This is due to the valuation being unjustifiable.

 Microsoft Stock

Microsoft Stock

Bottom Line

Mania occurs in financial markets all the time and especially at the top of long running bull markets.  We have seen it before with the tech bubble and we are seeing it now with marijuana stocks and "FANG" US tech.  Operating with rules based investing and proper valuations will protect you in the long run.  After all, risk can be inherent in the valuation as well as the company itself.