The mother of all reverse compounding problems

December 21st, 2008

The only proven way to achieve a passive double-digit yield to replace your income is to own businesses – either directly or indirectly through common stock ownership. But this creates a challenge.

The chart shows each of the bear market declines since the end of World War One. We are in the tenth decade and there have been twenty bear market drops of 20% or more –about one every five years. If you want to get even more specific, it is about sixteen months out of every sixty that we spend in bear markets. Of the twenty bear markets since WWI, eight of them have had a drop of more than 40% in the S&P.

It is absolutely true stocks go up over the long run. But your time horizon isn’t the long run when your objective is income replacement. You have bills to pay each and every month. When you are living off your portfolio, in order to pay those bills each month, you must sell some of the stocks and bonds in the portfolio. Based on historical market data, those sales will be at a loss a large percentage of the time. These regular losses create the mother of all reverse compounding problems.

You know about the power of compounding right? Which would you rather have? A million dollars or a penny doubled every day for thirty days?

Miraculously, a penny doubled thirty times is $5,368,709.12. But the bad news is it works the opposite in reverse. If you sell assets at a loss, you get reverse compounding. If you have a $100K stock portfolio and it loses 50% of its value, how much does it have to go up to get back to $100K? 100%! It has to double. That is reverse compounding.

The challenge is approximately one out every five years in the stock market is a down year. You have to sell off assets every year in order to eat. So, in order to live off the portfolio, you are going to have to sell stuff at a loss on a fairly regular basis. If those losses occur in the wrong order, it dramatically increases the chances of what academics call retirement ruin – a nice euphemism for running out of money before you run out of breath. This is known as the “sequencing of returns problem.”

Take, for example, the 17 year period from 1987 to 2003. The average return was 13.47%. Assume a portfolio of 100,000 taking $10,000 a year adjusted for inflation by 4% over those 17 years. Depending on the sequence of returns which produce the 13.5% average, the ending portfolio balance could be as high as $76K or as low as negative $187K! That is a big swing and obviously meaningful to your situation late in life.

Lesson Four: To avoid the sequencing of returns problem and negative compounding, an investor must avoid permanent losses of capital at all costs. Permanent losses of capital occur when assets are sold at a loss.

The preceding is an excerpt from my newest special report: How to not just survive, but thrive, in turbulent financial markets. Feel free to download the report and share it with anyone you think would benefit from the information.

This is not financial, legal or tax advice. Our goal is your financial success, but all investments involve risk including the possible loss of principal and results will vary. If you are interested in the Snider Investment Method, please read the Owner's Manual for a complete discussion of risks and benefits. More information can be found on our website or by calling 1-888-6SNIDER. Past performance is not indicative of future results.

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