This note is geared toward clients that are in the accumulating phase of building wealth. I'd like to show you how to easily generate a positive return on your investments even when the return of the underlying assets is negative. Yes -- that's possible.
There is a similar principle that applies during the distribution phase of life, when we're spending accumulated savings, so I'll get to that in an upcoming post.
Positive Returns from a Negative Investment
Here's the scenario: You've invested in the S&P 500 Index for a 4-year period. During that period, the real total return of the S&P 500 (dividends reinvested) is negative(-) 10%. Your investment performance report similarly shows a return of negative(-) 10% -- which is hard to stomach after a long four years.
But… Over the course of the four years you've invested a total $100,000 spread out on a monthly basis, and the account is now worth $113,000, which is a positive holding period return of 13%.
So the market produced the negative return on the blue line below for the four years beginning 2007, but your investment in the same market resulted in the positive return on the green line. How is this possible?
The answer is that volatility -- the crazy downturns that investors generally hate -- is a huge benefit for investors that are making regular additions to their portfolio, preferably monthly. As a matter of fact, within reasonable limits, higher volatility is the only way this mathematics trick works to our benefit as investors.
To show you how this is possible, let's exaggerate the math:
An asset has a negative return of -50% in month 1, and a positive return of +70% in month 2.
That's a total return of negative -15% for the 2-month period (the returns have to be geometrically linked to get this right answer).
Invested $100 at the beginning of month 1. At the end of month 1, you now have $50.
Invested another $100 at the beginning of month 2. At the end of month 2, you now have $255
So you invested a total of $200 and now have $255, for a total 2-month return of positive +28% -- when the asset lost -15%. Thank you, volatility!
Your ability to build wealth is not nearly as dependent on the returns of your investment portfolio as it is on your behavior as an investor. And one of the key behaviors we need to exhibit as investors is a commitment to consistent monthly contributions to our investment portfolios.
If I sound like a broken record in my routine letters urging you to systematically save and invest, this is why. It simply works.