If you played King of the Hill as a child, you'll remember the goal was to beat the other kids to the top. Not easy (at least it wasn't for me). But going down the hill was a breeze. The other kids and gravity were always ready to help!
It's easier to go down than up - this is the world of physics. The principle for how this applies to investments is called the Arithmetic of Loss.
The math: losses hurt more than gains help. For example, losing 5% is more negative than gaining 5% is positive.
To illustrate, consider a bigger percentage. Start with $100,000 and gain 50%, and you're $150,000. Great.
But as we know from the law risk equals potential return, where there's a chance for return, there's one for loss. Suppose the sword cuts the other way and you lose 50%. You'd have $50,000. Here's the rub: to get back to $100,000, you now have to go up 100%.
One more example: an investment of $100,000 earns 10% a year for three years. In the fourth year, it loses 10%. The ending value is $119,000. This computes to a return of just 4.6% per year. One down year disproportionately reduced the result.
You Can Only Lose All Your Money Once
|Las Vegas in the 1950s|
There is another important aspect to the arithmetic of loss. Gamblers in Vegas know
When you lose, you may become more risk averse. Math is compounded by psychology - studies show losses hurt more emotionally as well. With capital depleted, you'll likely be less tolerant of further losses.
Risk Tolerance May Change with Market Conditions
|Daily Linear Chart of S&P 500 from 1950 to 2013|
Does Buy and Hold Protect Against Losses?
Mathematically, just like in King of the Hill, it's much easier to go down than up. I don't know why it has to be this way. But kids - and investors - have to live with it.