Warren Buffett said, “Rule #1: Don’t lose money. Rule #2: Refer to Rule #1.”

Einstein famously quoted, “Compounded interest is the eighth wonder of the world.” However, what is not included in this quote is how it is important to avoid losses, for compounding is a double edge sword. The power of compounding only works when you do not lose money. This is also true when considering dollar cost averaging. If there is a continual downward market, dollar cost averaging only means that you will have more and more shares that lose value [as you purchase more shares when the price is lower than before]. Losses that compound are even more devastating than compounding interest [or gains].

For example, if one were to invest $100,000 and lose 20% the first year, the ending balance of the account would be $80,000. The following year’s return would have to be an increase of 25% [$80,000 X 25% = $20,000] just to break even. This does not include making a profit over the two year period; it just means that, over a two year period, the return would be zero. If the same $100,000 earned 20% per year compounded for three consecutive years and then suffered a 20% loss, the annualized compounded rate of return would be less than 8.5% rather than 10% [3 years X 20% = 60%, less 20% = 40% / 4 years =10%];

**Here is how the figures work:**

*Original investment $100,000*

*Year 1 20% increase $120,000 [Value at the end of year 1]**Year 2 20% increase $144,000 [Value at the end of year 2]**Year 3 20% increase $172,800 [Value at the end of year 3]**Year 4 20% decrease $138,240 [Value at the end of year 4]*

The time value of money shows that a $100,000 investment turning into $138,240 in four years equates to compounded rate of return of less than 8.5%.

Thus, the effect of losing money, even after gaining three years in a row [in our example] is worse than a steady increase. If, in the above example, the investment simply increased 10% compounded per year, after four years, the account would have grown to $146,410. The difference of $8,170 [more than 2% per year on average] represents the severe hit the investment takes when there is a loss of any real magnitude; thus, the importance of a steady positive return per year versus the ups and downs that an investment may experience over time.

The main reason for the powerful downside impact of losing money is that, if the loss happens before any gains [early in the investment years], there is less principal to work with to achieve a significant increase. If the losses happen after significant gains, then there is a fairly sizeable loss of investment as seen in the above example between years 3 and 4.

The larger the swings in increases and decreases, the more significant the difference in risk adjusted rates of return. The example above showed 20% increases for three years and then a 20% decrease. The difference in a fluctuating return [of both positive and negative years] reduced the return of a potentially steady rate of 10% down to less than 8.5%; however, what if the first three years were 40% positive and then a loss of 40% in year four?

**Here is how the numbers would look:**

*Original investment $100,000*

*Year 1 40% increase $140,000 [Value at the end of year 1]**Year 2 40% increase $196,000 [Value at the end of year 2]**Year 3 40% increase $274,400 [Value at the end of year 3]**Year 4 40% decrease $164,640 [Value at the end of year 4]*

Rather than a 20% return per year [40% X 3 years = 120% less 40% = 80% / 4 years = 20%/yr], the return is 13.27% per year [$100,000 turning into $164,400 after four years at 13.27% compounded annually]. The difference in interest rates of 6.73% is significantly higher than the previous example due to the higher percentages of rates of returns [both positive and negative]. In summary, the higher the rate of returns involved, the wider the gap in total rate of return when looking at an investment that has both positive and negative potential returns.

Since no one can accurately predict when investments will have their up and down years, it would appear that a more conservative, steady, return is more beneficial, as long as the return is not insignificant, and one needs to evaluate how an investment should be risk adjusted for comparison. For example, comparing a T-Bill, which is considered essentially riskless, might produce a return of 1% per year over a specified period of time, to an over the counter stock that might have wild fluctuations [as in our example{s} above] is not appropriate. The aggressive investment produced either the roughly 8.5% return or 13.3% return, so one might presume that one should always invest in the riskiest vehicle because of the huge gap between the riskless investment [1%] and the aggressive investment [8.5%-13.3%]; however, nobody knows if the aggressive investment will be a net positive return over a specific period. For example, what happens if the aggressive investment consistently losses money every year and never recovers; or maybe so much time has elapsed that the compounded rate of return is fairly small?

For such an example, one might look at the NASDAQ. By the beginning of 2000, the NASDAQ was about 4,200. 15 years later, the NASDAQ was about 4,600. A 400 point increase over 15 years turned out to be a paltry .61% compounded rate of return. The NASDAQ experienced a lot of volatility over those 15 years. The point here is not to presume that all investments that have a wide swing in returns will always, over time, produce a better return than a more conservative investment.

One cliché that is always heard is that, “Over a long period of time, the stock market has produced a good return for investors; you can allow for swings in the market, sometimes producing gains and sometimes producing losses, but, as long as you stay in the market, you will have a good return on your money” [or some such quote]; however, which indices is this quote referring to? The S&P 500? The Dow Jones Average? Small Cap Stocks?

Also, what other types of investments is this quote comparing to?

For example, for the last 30 years ending December 31, 2018, the Dow Jones Average produced an annualized compounded yield of about 8.2%. This obviously includes the incredible run up in the market from 2002 to 2007; the Great Recession starting in 2008, and the bullish years that followed. One might want to compare this against the Prime Rate. Although the Prime Rate is not necessarily indicative of what an investor could or should earn, it is a widely accepted interest rate in the market place; mostly for the cost of borrowing, but it gives a general idea of prevailing rates of interest and the direction of where they are headed. The Prime Rate during this last 30 years started at 10.5% in December 1988 and immediately rose to 11.5% by the end of February 1989. The “less” Great Recession that started in June 1989 pushed interest rates lower until July 1992, when the rate dropped to as low as 6%. Rates increased thereafter until they peaked again in May 2000 when the Prime Rate stood at 9.5%. It continually dropped until it hit a low of 3.25% in December 2008. It started to increase again in December 2015 and steadily went up until December 2018 where it hit 5.5%. The average annualized compounded yield for the Prime Rate over the last 30 years [if one could invest in such a benchmark], would have been just short of 7%, so, the Dow Jones Average over the past 30 years produced a greater return than the Prime Rate by a little over 1% per year.

However, what if we look at another relatively conservative investment such as a 1st mortgage? Private lenders have been producing private loans collateralized by real estate since Ally Ooop borrowed on his cave to put in a swimming pool 10,000 years ago. [Ok, not really, but the point is that private loans have been around since Biblical times]. Conservative, short term [less than three years] loans such as 1st mortgages on stable real estate [both commercial and residential] that were no higher than 60% loan to value over the same 1988-2018 period produced consistent positive returns of no less than 9% in any year and for many years were in the 10-12% range hitting as high as 15%. Even during the Great Recession [and including the less Great Recession], conservative investors were always in the positive during 1988-2018 if they kept to the formula of having low loan to values and relatively strong real estate areas because, although real estate declined, as did everything else during the recessions, a low loan to value protected the investment.

Many people believe the real estate market crashed during the Great Recession, but, in reality, real estate had a slow, steady decline. In the San Francisco Bay Area [a strong real estate market by most standards], the real estate market took four years to decline about 25% in total. Investors who stayed true to investing only in conservative mortgages did not see a loss of principal, and, in many cases, earned more than what they envisioned as a trouble borrower was mandated to pay late fees, and, in some cases, default interest that added upwards of 4-5% more than the note rate. Of course, the downside to this was the delay in receiving interest, but, in some instances, the investor received a windfall if the borrower failed to pay and the investor/lender acquired the real estate through foreclosure. Most lenders would prefer to just receive the intended interest they signed up for, but the notion of additional interest and possibly owning the real estate that was collateralizing the loan is a potential benefit. Lenders need to make sure they are willing and wanting to potentially owning the real estate they are lending on should there be a time when the borrower can no longer make the interest payments.

As with all investing strategies, an investor needs to do proper due diligence before investing money; this includes the stock market as well as real estate. That being said, as pointed out earlier, one needs to think about whether a more conservative, steady, positive return investment is more advantageous than one with wild swings of both positive and negative returns, especially if the conservative, steady investment outperforms the wild one.

*Edward Brown is an investment expert and host of the radio show, “The Best of Investing.” He has multiple published works, including an interview with the Wall Street Journal, and has also served as a chairman of the Shareholder Equity Committee to protect 29,000 shareholders representing $500 million REIT. Edward is also a recipient of a prestigious MBA Tax Award. *