Prudent Investing is a Combination of Growing AND Protecting Investments

If you listen to the financial services industry, there is only one way to invest. The only strategy that the financial advisor community has focuses on is growing investment accounts. It is a performance-based system for investing.

The problem is that there is very little emphasis placed on protecting investments when the markets go through rough times. What happens when if a bear market comes along? The advisor community doesn’t have a strategy for that type of environment. Thus, they remind you that you are a long-term investor and to just “ride it out.”

This strategy is dangerous for one reason. You make money in the bull markets and you give most of that money back during the bear markets. That is the danger of the one strategy investment process.

The focus is always on the good years. It is all about performance. Now the financial services industry bases the notion of performance on an illusion. If you were to look over the last 79 years, the stock market (represented by the Dow Jones) gained money 66% of the time and only lost money 44% of the time. Therefore, the conclusion is that the emphasis should be on the positive good growth years because there were as much 1/3rd more good years. Why care about the loss years since there are more growth years?

Well there in lies the illusion. The stock market might have lost only 44% of the time. However, the negative years had much more of a negative effect on investment values than the benefit gained from the positive years. The reality is that there is major importance to be placed on protecting your investments from the bad investment years.

Think about these percentages for a moment:

If you lose: % required to break even

-10% +11%
-20% +25%
-30% +43%
-40% +67%
-50% +100%
-60% +150%
-70% +233%

You could easily lose 50% of your money in a bear market over a short time period. Unfortunately, it would take an investment return of 100% just to break even. It would take a long time to recover.

Take for instance the greatest stock market crash of all time. The 1929 stock market crash created an 88% loss in just a mere 3 years. It took 3 years to wipe out 8 years of investment gain. Then it took another 22 years just to get back to even again.

This is why it is important to have a strategy to protect against loss. Negative years in the stock market can be much more devastating then the benefit from the good years.

Copyright © 2008 Prudent Money and Bob Brooks. All rights reserved.