As the Sage of Omaha eloquently put it, the number one rule of investing is Don’t Lose Money. At first sight it is a blatantly obvious piece of advice although I suspect most investors don’t realize just how sophisticated it really is.
The Case Study
Allow me to share a hypothetical case study with you. Suppose you invested $100,000 in the S&P 500 on January 1, 2006. For the purposes of this example, there are no management fees or costs. During 2006, this index grew 13.62% so at the end your investment would be worth $113,650. The following year it was up 3.53% so your investment grew to $117,661. So far so good. But as we all know, 2008 was not a very good year. The market dropped 38.49% so now your investment value dropped to $72,385. However, during 2009 the market came back with purpose closing the year with a 23.45% gain and lifting your investment’s value to $89,359. And the rise continued in 2010 when the market was up 12.78% lifting your portfolio to $100,780. During 2011 the S&P 500 was flat so your value was unchanged.
In summary, during a six year spell, your investment had a flat 2011, four positive years with cumulative gains of 53% and one losing year where your investment lost 38%. So we should be up 15% right? Actually we’ve made a life changing $780 over 5 years. That ads up to two lattes a month! That’s before we consider the facts that over the same period, inflation “ate” over 15% of our investment’s purchasing power and stock market investments usually aren’t free of management costs.
The Explanation
How could this be? Because in all kinds of investing every step back is worth about two steps forward. Every loss of capital takes almost twice the gain to get back even. It took until January 2013 for the S&P 500 to get back to the 2007 high again! Six years to get your head back above water with the leaches of inflation at work the whole time.
I told you this was a hypothetical scenario but unfortunately this is the bitter reality that many people face all over this country. It’s how hard working folks come to consider pulling their hard saved money out of their Roth IRA after it sits idle for an entire decade as those same fund managers draw billions in fees.
How real estate investments are different
But wait a second, you might ask – real estate isn’t immune to capital losses. In many parts of the country real estate prices plunged at least as much as the S&P 500 in 2008. But there’s a huge difference between a stock portfolio that relies primarily on value increases (appreciation) and a long term real estate portfolio. Say you invested the same $100,000 in real estate in 2006 and it followed the same path as the stock portfolio. In other words, the value dropped substantially in 2008 then recovered back to the same amount by 2011. If you held on to the property through the whipsaw, your capital would be intact.
But the big difference is that throughout, your portfolio gave you a return of 12%/year independently of the value of the capital. So in this case, a real estate portfolio acted more like a dividend paying stock but with 3-4 times the return. Let’s face it – it’s much easier to ride out a bad market while making 12% a year in the interim. Not to mention that there were fundamentally stable markets all across the country that didn’t experience the value roller-coaster as much (or, at all).
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What’s Buffett’s rule number two of investing? Don’t forget rule number one.
