A few weeks ago, I was speaking to a newer investor who had listened to an episode of the podcast and had heard me talking about being “down 40, 50, 60%” on an investment. As someone that hadn’t been investing long, this had concerned them, and they wrote in to ask if I could clarify how I could justify losing capital like this when I spoke about financial responsibility so much.
“I work hard for my money and I haven’t got a lot of capital to invest. When I was growing up, my parents always told me that investing was just gambling and that I should never do it. Now I’m older and understand the difference but how can you justify losing 60% of an investment and saying it’s not gambling? I’d never be able to live with myself if I lost 60% of my capital!”
Great question!
As a long-term investor, I sometimes forget that to someone used to putting money in a savings account, the thought of losing 60% must be horrifying. After all, if you woke up one morning and the bank told you that they’d lost 60% of your cash, you’d probably be grabbing a pitch fork and flaming brand rather than calmly discussing risk vs. reward. To someone that doesn’t invest regularly, it’s hard to tell the difference between a paper loss and a real loss – after all, if the goal is to grow your wealth over time then losing capital is surely terrible regardless of whether it’s on paper or not?
What do I mean when I talk about being “down” on an investment?
Well, first of all, let’s discuss the difference between realised and paper returns. Thanks to the wonders of technology, the modern investor can get a minute-by-minute update of the value of their investments. Some days they will go up, other days they will go down. As such, it is important to differentiate between realised returns and paper returns.
A real return (or loss) is generated when an investment is sold, at such time ownership is transferred in exchange for cash. By comparison, a paper return is one which only exists in theory as a reflection of the price you would be offered if you chose to liquidate the investment at that precise moment in time. If you simply keep holding the investment, that return will continue to change as the market continues to work to determine the true value of the asset. You haven’t actually lost any capital until you liquidate the position.
Most of the time, when I talk about being up or down on an investment, I’m talking about paper returns. As a long-term investor, I’m not constantly chopping and changing my portfolio, which brings me onto my second point.
Losing capital must be contextualised
The overall goal of investing (for me at least) is to build wealth. As such, there is only a single number that really matters and that is the compound annual growth rate of my portfolio. With a savings account, you are paid a fixed rate of interest – say 3% – on the balance of your account. This rate is known and so unless the bank becomes insolvent, you are guaranteed to get this rate of return.
The compound annual growth rate is the equivalent rate for an investor. Unlike a savings account, where the return rate is fixed, an investor makes a variable rate of return – nothing is guaranteed. Some years, we do well (see my 23% return in 2021 and my 19% in 2016) and other years, not so well (see my 11% loss in 2022). By taking the cumulative returns of your investments over time, you are able to calculate your compound annual growth rate, which is effectively the average return generated over more than a year. For me, this is 8.25%, which is significantly higher than the two or three percent paid by most banks accounts in the UK.
Unlike cash, which generally loses money to inflation, investing has the potential to help beat inflation and so protect your purchasing power. The danger of not investing can be seen all around us. In the year 2000, a loaf of white bread cost about 50p but in 2024 it costs over £1.30. As such, £100 saved in the bank would have bought you 200 loaves of bread but today would only buy you 76.
“But Henry, what about interest?”
OK, let us assume you put your cash in the bank earning 3%. After 24 years, you’d have a little over £200, which would buy you 153 loaves. Thanks to inflation, you might look wealthier on paper, but you’ve still lost the ability to afford 47 loaves of bread. Now imagine that process compounded across everything – food, clothes, petrol, holidays. It starts to explain why over time, people that just save in cash struggle to maintain their standard of living.
What is the bottom line?
Of course, the greater return generated by investing doesn’t come without risk and that risk is the risk of losing capital. When you deposit money in the bank as cash, you are actually lending the bank money. They then lend this money to other customers in the form of mortgages and credit cards, charging them multiples of the interest they pay you. Some of the banks buy bonds, lending the money to hedge funds, real estate developers and businesses, who use it to generate returns, again, usually multiples of the interest the bank pays you.
These entities are then the ones taking the risk, and both they and the bank use your money to generate profits for themselves. By comparison, when you invest, YOU are the one taking risk, and that risk is the risk of losing capital. Unfortunately, leaving your money in the bank also comes with a risk – it’s just better hidden. Unlike the risk of investing, where with time and skill you are likely to do well, the risk of leaving your money in the bank is the risk of losing purchasing power every year whilst thinking you’re saving. Although theoretically you can beat inflation, in reality the bank nearly always pays a lower rate of interest than the rate of inflation over time, meaning that your money is becoming less and less the longer it sits in the bank.
The alternative is to take the risk of investing – namely, that an investment you make is a bad one. This can occur due to a variety of factors, perhaps an economic downturn, poor management, or lack of discipline with your analysis (i.e paying too much or buying bad assets).
If you’re still not convinced, consider this. How do you intend to calculate the risk you’re taking by leaving your money in the bank? What is the “X Factor” for your loss of purchasing power?
The government produces a variety of statistics on inflation including goods inflation, services inflation, consumer pricing index including housing, and the consumer pricing index excluding housing. Of course, they government also has a bit of a vested interest in presenting a low rate of interest, so who knows how accurate these really are.
If you’re not such a fan of the conspiracy theories however, it’s undeniable that your personal inflation rate will differ from those published by the government. After all, in a year you move house, the cost of decorating services, van hire, and furniture are probably more important than the cost of a foreign holiday, which is impacted by things exchange rate, airline prices, and holiday clothes. Likewise, if you’re vegetarian, the change in prices of meat won’t impact you at all, but you would be impacted to a far greater extent by the price of a bag of potatoes.
The government simply takes a basket of goods and services measured across the country – for example, in 2023 the basket included chicken kievs, premade mashed potato, meat free sausages, sugar, energy drinks, vodka, tracksuit bottoms, cycle helmets, ceramic tiles, liquid kerosene, a baby’s high chair, a gas fireplace, a lawnmower, and dating agency fees…none of which I or any of my household purchased.
Instead, we DID purchase, among other things, gardening services, train tickets, three suits, and ground coffee, all of which increased by far more than the headline 8% rate of inflation. Of course, just like the government’s basket, we bought much more than just these items, and so calculating the exact rate becomes a bit of a headache.
Without knowing your personal rate of inflation though, it’s impossible to know exactly how much purchasing power you’re losing every year – so how can you really know you’re happy with it or not? Now, more recently, interest rates on cash have increased as central banks increased their base rates. Let’s say you manage to get paid 5% on your savings for a year or two. The only problem is that the headline rate of inflation has been more than double that for part of the time – so what do you think your personal rate has been?
Coming back to the paper losses in a portfolio, therefore, individual incidents of losing capital don’t matter as much as the compound annual rate of return, or CAGR. This is the vital figure to watch. A negative CAGR means the investor is losing money over time, not just to inflation, but actually losing real capital. A positive CAGR reflects an investor that is growing their wealth over time. The higher the CAGR, the better the investor.
At 8.25% since 2015, my returns have been fairly pedestrian, but by pursuing incremental improvements I am seeking to drive this up to 15%. Of course, there is no guarantee that I will achieve this – but to me, the occasional loss in a portfolio with an 8% return is infinitely more desirable than a guaranteed loss of purchasing power of an indeterminate value over fifty years.