The Importance of Financial Defense
From: Sound Income Strategies, LLC
The great Alabama coach “Bear” Bryant once said, “Defense wins championships,” and you can bet that almost every great coach in nearly every sport has shared that same philosophy. Just think about some of the great sports dynasties, teams that won championships year after year: the Green Bay Packers under Vince Lombardi, the Boston Celtics under “Red” Auerbach, the Yankees under Joe Torre. You could go on and on.
All of these teams knew how to score, yes, but they all started with the premise that a strong defense made their offense better. Strategically, they knew how to win games, but they focused first on strategies that ensured they wouldn’t lose games.
Why is that same approach so critical when it comes to your finances and, in particular, saving and investing for retirement? Well, it’s simply because when you’re talking about your “life savings,” losses can potentially have a huge impact on your life! How huge? Well, consider the fact that if you have all or most of your investments in the stock market and your portfolio loses 50 percent of its value, you will need to regain 100 percent of it in order to break even. That takes time and depends on whether or not the market drops again.
The fact of the matter is, this very thing has happened to domestic investors in the US twice in the last 18 years. From the beginning of 2000 through March 2003, the stock market, based on the Standards & Poor’s 500 Index, dropped almost 50 percent. It took until October 2007 to recover. That means it took approximately three years for the market to drop by nearly 50 percent and then four and a half years to make a 100 percent gain and get back to where it was some seven and a half years earlier. Then, lo and behold, it dropped again. This time, it took roughly seven years to recover to its previous high. So, there have been two drops of approximately 50 percent or more and subsequent rebounds in the last 18 years.
Time is Money
So, let’s go back to the question: “how huge” an impact did all this have on investors oblivious to the importance of financial defense (who may, in fact, still have most of their money in the market despite those two major drops)? To see the real impact, we have to look further than the fact that these investors have twice had to re-double their lost gains with virtually no portfolio growth over this entire period. We need to consider the amount of time that has elapsed.
For an investor to recover from a 50 percent loss with a 100 percent gain over, say, 10 years, they would have to average 7 percent a year over the length of that recovery period. By the same token, to make the recovery over 7 years, they would have to average about a 10 percent average growth rate. In that sense, those investors from March 2003 to October 2007 were lucky because they made that 100 percent break-even gain in only 4 and a half years, which represents an annual average growth rate of 16 percent. That sounds pretty good until you factor in a little thing called inflation. Over the last 18 years, investors lost approximately 42 percent of their buying power due to inflation. That means what was worth a dollar 18 years ago is now worth only 58 cents.
But, let’s go further and factor in something called “lost opportunity cost.” Whether we’re talking 4 years, 7 years, or 13 years, consider the fact that investors waiting and hoping to regain stock market losses over all that time could have been earning money elsewhere. For many parts of the 2000 to 2007 period we’re talking about, for example, those investors could have had their money in FDIC-insured bank CDs that were averaging somewhere between 3 and 5 percent annual returns. The 3 to 5 percent they could have earned while their market losses were recovering to previous levels is the lost opportunity cost.
The point is that when you add inflation to lost opportunity cost, it’s pretty easy to see that those investors who were so relieved when their portfolios finally regained their original value over the course of several years, really recover or break even. They did, in fact, experience losses, and depending on what alternative investment options they might have pursued, those losses might have been significant.
