Recovery Rates

Investment Recovery Rates

Watching coverage of the stock market, investors will often see daily activity quoted in point performance.  On a strong day, the Dow Jones Industrial Average may rise 250 points.  On a poor day, the S&P 500 may be down 26 points.  What does this even mean to the typical investor? Often quoting stock market index performance in raw point totals can either create unrealistic euphoria or irrational fear as most don’t understand what these figures actually communicate.  As a result, actual investor behavior may deviate from an intended investment plan. The further reactionary behavior causes an investor to deviate from an intended plan, the more difficult an appropriate recovery may become over the long-term.

A better indicator for the individual investor is to focus on percentage performance - though we’d argue an even better policy is to not focus on the stock market on a daily basis to begin with, which is an entirely separate point and assuming you have an established plan and strategic asset allocation.  However, when monitoring short-term swings and market movements, percentage changes are a better indicator, yet even this is only useful to investors when understood within a proper context. it is important to think back and review some basic mathematical principles to truly appreciate the significance of each rise and fall of a portfolio or market index when measured as a percentage of a portfolio.

One key principle that investors often forget in the day to day musings of the market is that a temporary downturn of X% of an investment followed by a subsequent rise of X% will not fully recover an investment’s initial value. Similarly, a temporary increase of Y% of an investment followed by a decrease of Y% will not bring an investment back to it’s initial value. Lets review a basic scenario to illustrate the point.

John Doe has a portfolio with a value of $1,000,000 which decreases 5% in Year 1, followed by 3% and 2% increases in Years 2 and 3 respectively. The results would appear as follows:

Recovery Rate 1.PNG

Its clear to see that despite the same fall and rise of 5% over an aggregate period of time, John ends up with a lower value than he started with.  This result makes sense when we stop to think about the facts involved, but is not always intuitive. This analysis does not even consider the time value of money considerations in which by Year 3 $1,000,000 does not necessarily retain the same purchasing power as it did in Year 1. This means that not only does a 5% recovery not produce the same starting value, John in our example has also experienced a loss in purchasing power due to basic time value of money principles.

The opposite becomes true if the return streams are reversed, as seen below.

Recovery Rate 2.PNG

The same cumulative percentage rise and fall produces a different figure. While the difference in results in this simple example may appear immaterial, if compounding occurs over many periods the differences can become significant. 

What we can determine from these results is that to return to the original value, a decrease in value will require a recovery rate of return in excess of the rate of decline, while an increase in value will require a rate of decline in excess of the preceding rate of return – over the same time period.  Therefore, the sequence in which these returns occur can hold great significance for an investor’s portfolio. So if a portfolio or market does fall over a given period of time by a given percentage of it’s beginning value, what corresponding percentage does it take to at least recover the initial value?

Recovery Rate 3.PNG

In an instance where the portfolio declines, it will always take an even greater rate to recover - as we’ve established by now.  We can see that the extent of the recovery is not a linear relationship and as the initial decline becomes more severe, the rate required to reach the beginning value will grow exponentially.  While a 50% decline is unlikely, the Great Financial Crisis taught us that modern markets are not immune to such shocks.  Such a loss has scared some investors from global capital markets entirely.  However, even a more likely decline such as 15 or 20%  - as we saw from peak to trough in 2018 - requires a rate of return that can take several years to recover in some cases.

What are the largest lessons an investor can learn from these sobering figures? While risk and reward are traditionally correlated, proper management of this risk is essential. Greater risk may mean a greater array of potential outcomes, not necessarily superior returns.  Therefore, diversification is key and the sequence of returns can matter significantly. These factors, among others, are ideally managed in coordination with a broader financial plan tailored to an investor’s specific goals. One investor can perhaps withstand a poor temporary sequence of returns, while those with less time to reach or sustain their goals cannot accept such risk. While a portfolio invested solely in equities may experience greater volatility and substantial downturns, a portfolio that is designed to be balanced in the proper areas and matching the risk profile and timeline of its beneficiary will be better suited to withstand market volatility and severe market corrections or declines.

Further, timing can make or break an investment program’s success. As no one can guarantee what this month, quarter or year will deliver from an investment perspective, the evidence has suggested that we should not aggressively attempt to time the market. If an investor becomes invested at the right time they can experience great market advances while subsequent declines will not be as impactful to their overall wealth. However, if the opposite is true and an investment occurs at a poor time and experiences a decline, the road back may be difficult and the presence of persistence and belief in your investment plan becomes even more important. Having a properly designed and diversified portfolio while committing to a long-term investment plan can help neutralize shorter-term market swings and timing risks. This can make the difference between investment growth and preservation or unnecessarily losing a material portion of one’s wealth.

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