Defining the Opportunity

November 07, 2022
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Do you believe the market will eventually recover to its previous high?

If you have a well-diversified portfolio – one invested in hundreds of companies across dozens of sectors and countries, I believe you ought to believe it will.

If you disagree, there is no point in reading further. In fact, if you disagree there is no reason to invest a single penny of your hard-earned wealth in the stock market. Non-perishable food and bullets will prove wise investments if the market never recovers. Probably ought to stock up on fresh water as well. Welcome to the apocalypse.

Our portfolios would be the least of our worries.

So I’m working from this assumption: the market will recover at some point. When? No idea. Will it go down further first? Still no idea. You don’t know either and neither does whatever talking head is currently blabbering on CNBC. But I do think we can all agree on the fact that it will eventually recover.

Which brings us to a rule of investing that people don’t spend enough time talking about:

Price and expected returns are inversely correlated.

In layman’s terms - if prices are down, expected returns are up.

Note this holds consistently true for diversified portfolios. It is not always the case for individual stocks. I talked to someone the other day who bought an individual stock just before its 95% slide over the last year. I don’t think he should be getting excited about his expected returns. Anything can happen to an individual company’s stock.

But if you have a well-diversified portfolio and operate under the assumption the market will recover, then mathematically your expected returns increase as the value of your portfolio declines.

Again, I don’t know when the market will turn around. But we’re operating under the assumption it will. At some point. And the lower it goes, the higher your expected returns become. Inverse correlation.

Which provides some useful insight should you find yourself trying to decide what to do with extra funds you have available.

I know you don’t like math, but there are two helpful formulas to consider.

The first determines what percentage gain an investment must achieve to get back to even. A common mistake is the belief that a 25% loss followed by a 25% gain makes the investor whole. Not so fast. A $1,000 portfolio that suffers a 25% loss is valued at $750. A 25% gain from there gets you to $937.50. Still 6.25% less than you started with. Here’s the formula:

 % Gain to Recovery = [(1 / (1-% loss) – 1]*100

Plug in the numbers and you’ll find that a 25% loss requires a 33.3% gain to return to even. Since I suspect your eyes glazed over with boredom the moment you saw a formula containing brackets, I included a handy chart below. We’ll get to that in a minute.

The second formula calculates your expected annualized returns given (a) the % Gain to Recovery calculated above and (b) the number of years to recovery:

Expected Annual Return = [[(1 + % Gain to Recovery) ^ (1/# Years to Recovery)] – 1]*100

Let’s assume you expect it will take three years for the portfolio down 25% to recover. Plug those numbers in, and you’ll find your expected annual return over the next three years is 10%.

In the interest of keeping your calculators tucked safely away in the drawer they’ve long been forgotten in, here’s a chart I compiled:

Let’s say your portfolio is down 25% year to date and you expect it will take about three years to recover. That implies an expected return of 10%/yr. for the next three years. Perhaps your portfolio drops to 30%. That’s a bummer. But every coin has two sides. The flip side is your expected annual returns over the next three years are now 12.6%.

All market downturns are opportunities.

With a few simple assumptions and the formulas listed above you can define the opportunity. 

Don’t waste it.


Sean Cawley, CFP®

Neither asset allocation nor diversification guarantee against investment loss. All investments and investment strategies involve risk, including loss of principal.

Content here is for illustrative and educational purposes only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy. Results will vary. Past performance is no indication of future results or success. Market conditions change continuously.

This commentary reflects the personal opinions, viewpoints, and analyses of Resolute Wealth Management. It does not necessarily represent those of RFG Advisory, clients, or employees. This commentary should be regarded as a description of advisory services provided by Resolute Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time without notice.