Here’s an easy riddle:

Up.
Down.
Down some more.
Up.
Down in a hurry.
Up.
Up again.
Down, then up in the same day.

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Who am I?

  • A) A Bipolar mood disorder
  • B) The stock market
  • C) A roller coaster
  • D) All of the above

Those answering A) may want to consider professional help. Those answering C) are having more fun than the rest of us. For all those who quickly identified with B), keep reading.

Even if you aren’t aware of the exact numbers, you probably understand stock markets have been somewhat erratic in the past few months (or even the last year…thanks 2020). They move up, they move down; and there’s not much predictability. We’ve even seen the masses using the market in unprecedented ways this year alone—like GameStop and AMC. Combined with the fall-out from other risky investments like DogeCoin, some people warn that investors may be on the verge of sustaining some substantial losses.

Historically, loss would not be an unusual occurrence. Recessions, depressions, and bear markets have been a regular part of the financial landscape just as much as upward trends, booms, and bull markets. Typical advice suggests that even with the ups and downs, the long-term returns are worth it, so we have been conditioned to accept some losses along the way. However, that doesn’t mean we have to settle for significant loss.

Loss Aversion Theory Abounds

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Losing money is a concept that perhaps doesn’t get as much attention as it should in financial programs, and in many ways, the losses you incur may have a greater impact on your total wealth–and your psyche—than the gains you make.

Loss aversion is the tendency to focus on avoiding losses instead of acquiring gains. Research from the Journal of Economic Perspectives shows us that loss aversion occurs because losses have effectively twice as much psychological impact as the same amount of gain. Although this study was conducted in 1991, several more recent studies have confirmed these findings again and again.

What happens when you have a stock-correlated asset like a 401(k) that incurs significant losses? The closer you are to using that account for income, the harder those losses are going to impact you.

There are several mathematical examples to illustrate this idea.

Here’s a simple illustration.

Suppose you have $10,000 in some non-guaranteed financial vehicle (i.e., the account values may fluctuate). For three years in a row, the account delivers a 10% annual return. At the end of the third year, your account would have grown to $13,310. Here’s the progression:

  • Beginning balance: $10,000 Annual Return
  • End of Year 1: $11,000 (10% increase)
  • End of Year 2: $12,100 (10% increase)
  • End of Year 3: $13,310 (10% increase)

Three out of four years you gained 10%, right? Now consider the impact of the one bad year: The average annual return is more than halved. Through the first three years, the average annual return was 10%. However, the “one bad year” reduces the average annual return for the four-year period to just 4.62%! In order to get back to averaging 10% a year, your account must earn over 34% in the fifth year! Look at the math. Here’s what comes from five years of steady 10% annual returns:

  • Beginning balance: $10,000 Annual Return
  • End of Year 1: $11,000 (10% increase)
  • End of Year 2: $12,100 (10% increase)
  • End of Year 3: $13,310 (10% increase)
  • End of Year 4: $14,641 (10% increase)
  • End of Year 5: $16,105 (10% increase)

If there’s a blip in the fourth year, making up for it in one year requires a steep increase.

  • Beginning balance: $10,000 Annual Return
  • End of Year 1: $11,000 (10% increase)
  • End of Year 2: $12,100 (10% increase)
  • End of Year 3: $13,310 (10% increase)
  • End of Year 4: $11,979 (10% decrease)
  • End of Year 5: $16,111 (34.5% increase)

Even if you spread the loss over multiple years, it would take six years of earning 13.75% each year to average 10% for 10 years, all because of one bad year.

  • Beginning balance: $10,000 Annual Return
  • End of Year 1: $11,000 (10% increase)
  • End of Year 2: $12,100 (10% increase)
  • End of Year 3: $13,310 (10% increase)
  • End of Year 4: $14,641 (10% increase)
  • End of Year 5: $16,105 (10% increase)
  • End of Year 6: $17,716 (10% increase)
  • End of Year 7: $19,487 (10% increase)
  • End of Year 8: $21,436 (10% increase)
  • End of Year 9: $23,579 (10% increase)
  • End of Year 10: $25,937 (10% increase)
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  • Beginning balance: $10,000 Annual Return
  • End of Year 1: $11,000 (10% increase)
  • End of Year 2: $12,100 (10% increase)
  • End of Year 3: $13,310 (10% increase)
  • End of Year 4: $11,979 (10% decrease)
  • End of Year 5: $13,626 (13.75% increase)
  • End of Year 6: $15,500 (13.75% increase)
  • End of Year 7: $17,631 (13.75% increase)
  • End of Year 8: $20,055 (13.75% increase)
  • End of Year 9: $22,813 (13.75% increase)
  • End of Year 10: $25,950 (13.75% increase)

In the typical paradigm, “more risk equals more reward.” However, the true definition of risk is the likelihood of loss. Remember, this is all the result of one bad year! And while some people are willing to experience massive volatility for a possibility of reward, there’s very little market appeal to loss prevention or certainty. Certainty often means smaller annual gains, however there’s no market risk. That means you don’t ever have to play catch up after one bad year. Optimizing your wealth means having a certain financial foundation–so you can avoid risk entirely, knowing your money can only grow. (And even leave a little room for uncertainty if you so choose, because you know you have something certain to back it up.)

If you’d like to work with advisors who understand the importance of not losing money, contact Partners for Prosperity today. Those who work with us aren’t glued to stock market reports and staying awake at night, because we utilize certain assets and proven, guaranteed, accelerated saving solutions.