[Editor's Note:  This is a guest post submitted by Felix Chapovsky, MD, a physiatrist in Pennsylvania.  In it he discusses the often misunderstood but important difference between arithmetic means (average annual return) and geometric means (compound annual growth rate or annualized return).  We have no financial relationship.  Be aware that I'm not a fan of active stock trading as an investment method.]

I first became interested in the stock market during residency, when the thought of finally having to pay off all my student loans hit me. It was a pretty daunting feeling know that I had to pay back over $200,000 for my education and I thought the market would be a great way to help make some quick money. Boy was I wrong.

I have been an active trader in the market for 6 years. By active trader, I mean that instead of utilizing a buy and hold strategy consisting of a diversified stock portfolio, I try to capitalize on intermediate term price movements in the stock market by investing in individual stocks that I feel offer the best opportunity for significant price appreciation. I have made many mistakes during my trading career, more than I could possibly discuss in  this article, but I have learned something from each of them and this has made me a better trader.

Whether your goal is to learn how to trade individual stocks or to become a passive investor through asset allocation, there are certain rules that must be followed in order to achieve success, the most important of which I want to  share with you today. What I am about to show you may seem very simple on the surface, but it took me 5 years to really put it into practice with my trading strategy and it has made all the difference.

The Stock Market Is Not A Casino

Last year, I had a good friend call me up and say “Hey. I hear the Facebook IPO is coming. Can I give you some money to invest for me?” I told him no but I get these types of phone calls rather frequently from colleagues of mine who think of the market is more of a casino and a way to make easy money. Nothing could be further from the truth.

Experienced Investors Concentrate on Risk

The problem is that most people spend 95% of their time trying to find the perfect strategy or the next “big stock” but this rarely leads to success. In other words, the majority of people focus most of their time on trade identification, but what they should be spending their time on is developing a risk management strategy.  Even if you prefer a diversified asset allocation approach, it is critical for you to understand how to manage risk. We have had two 50% market declines in recent history, in 2000 with the internet stock bubble and during the 2007-2008 financial crisis. In 2008, 40 million 401(k) account holders lost a total of $1 trillion worth of assets, but if they had spent some time focusing on risk, they could have saved themselves a lot both in terms of time and money.  [Editor's Note:  I'm not sure what the author is suggesting these investors should have done to focus on risk, but a diversified stock/bond portfolio helped minimize losses in 2008, and rebalancing and using a buy-and-hold approach served many investors, including myself, very well to make up their losses in 2009-2011.  An investing plan that requires me to be able to predict the future with any kind of certainty is a plan that is likely to fail.]

Remember, even if your only goal is to invest money in your 401(k) or some other retirement vehicle, it is up to you to determine how your money is allocated. You can seek all the counsel you want but the responsibility lies with you. You work very hard for your money and you must learn how to protect it.

Arithmetic Means Are Not Geometric Means

The lesson I am about to teach you can best be illustrated with an example. Say you are looking at 3 different mutual funds and are deciding in which one you would like to invest. Below are the yearly returns for each fund during the last 3 years. With no other information, take a moment to write down which fund you would invest in an why.

Fund 2010 2011 2012
A -18 20 6
B -30 25 16
C 8 -10 10

Which mutual fund did you pick? If you calculated the average annual return for each fund, then you came up with the following table.

Fund 2010 2011 2012 Avg Return
A -18 20 6 3.33%
B -30 25 16 3.67%
C 8 -10 10 2.67%

If you are like most people, you picked mutual fund B since the table shows it offers the best return of the available choices. You would be wrong. Intuitively it doesn't make sense, math is math and you can't argue with results, but in order to gauge the value of the output you must first consider the relevance of the input. This is not regular math, it is stock market math, and there is a big difference.

Look at the table below and see if you can figure out why fund B is actually the worst possible choice above.

% Loss % Gain Needed To Get Back To Even
1 1.01%
5 5.26%
10 11.11%
15 17.65%
20 25.00%
25 33.33%
30 42.86%
35 53.85%
40 66.67%
45 81.82%
50 100%
75% 300%
90% 1000%

Losses Matter More Than Gains

There is a stock market saying that says “Winners take care of themselves, losers never do.” Say you put on a trade and it shows you a 1% loss. This is not a big deal and you only need to return 1.01% of the next trade to get back to even. Your second trade shows you a 5% loss, also manageable as you only need to earn 5.26% on the next trade to get back to your initial trading capital. If you go down the table, you will notice that winners and losers are not correlated in a linear fashion. In other words, losses work exponentially against you and the more significant your loss the harder it is to recover from. This may seem like a simple concept to understand, but the importance of this can't be overstated.

Lessons Learned

There are 2 important points to be gained from this information.

  1. The greatest traders of all-time were right at most 50% of the time, even during bull markets. Let's assume for this discussion that you can replicate their success and you have a 50% batting average on your trades. The size of your winning trades must be bigger than the size of your losing trades or you will lose money overall.   Look at the table above; if you take a 20% loss on a trade, you must make 25% on your next trade just to get back to even. If you only get back 20%, you are not even getting back to your initial trading amount. If you repeat the same cycle 10 times, you have lost a lot of money.
  2. For you mutual fund investors out there, the key point is that average annual return is meaningless when it comes to calculating the actual growth rate of your money. Looking at our 3 choices of mutual funds, if you were to calculate how much $100 invested in 2010 would be worth at the end of 2012 you would get the following results.
Fund 2010 2011 2012 Avg Return Annualized Return Dollar Value
A -18 20 6 3.33% 4.30% $104.30
B -30 25 16 3.67% 1.50% $101.50
C 8 -10 10 2.67% 6.90% $106.90

Look At The CAGR

It can't be stressed enough, losses have a more significant impact on your portfolio than gains so even though fund B had a great 2011 and 2012, this still was not enough to overcome the 30% loss experienced in 2010. Also consider that this only encompasses 3 years of data. Mutual funds report their average 1, 3, 5 and 10 year returns. You should realize now that you must take these numbers with a grain of salt and that making investment decisions based solely on average returns is a mistake. [Not to mention making investment decisions based on past performance of any type- ed]  The best way to use average returns is to see how your fund performed relative to the stock market in general. For example, if the market was down 15% and your fund was down 10%, you are not losing as much as the market so that is good. This also means that if the market was up 15% you probably would be up less than the market as well. This is not necessarily a bad thing because everything should be seen in terms of risk and reward. Preservation of capital is most important, so even if you are not making as much you are losing less during a bear market. The most important number you need to look at is the compound annual growth rate of the fund you are interested. If you don't see this number, ask for it.

To sum it up, it is not stock market gains you should be worried about, it is losses.  This is very relevant to our current market situation. During the financial crisis, the S&P 500 suffered over a 50% decline from its highs in late 2007. At the time this post was submitted, the S&P was about 1% away from those previous highs and since that time has eclipsed that mark. This means that if you had money invested in the market in 2007, it has taken you almost 6 years just to get back to even! Forget about all the average returns you have seen in your statements over the years, if you haven’t put any additional money in your account you are just now getting back to where you were before.

Have A Plan For The Next Bear

What I really want you to take away from this is to understand that you must take risk into account when making investment decisions. What if you were of retirement age in 2008?  You were toast. You lost 50% of your entire net worth in the span of 1 year, all because you spent too much time focused on growing your money, and not enough time on protecting your money. You would never give a patient medication without first considering what potential side effects there could be and what you would do should they occur, right?  Shouldn’t you treat your investment portfolio the same way?  [Editor's Note:  An investor nearing retirement probably shouldn't have an asset allocation consisting of 100% stock, which would have led to a 50% loss in the 2008 bear market.]

One thing I can tell you with absolute certainty is that we will get another bear market in the future. Trying to predict when this will happen or how deep the correction will be is impossible so it is not even worth the effort to try. All you can do as a market participant is develop your own risk management strategy so that when the eventual market downturn comes, you have a plan to protect your capital. Spend at least a little time thinking about risk. It is well worth the effort.

What do you think?  What methods do you use to deal with market risk?  Comment below!