The chart below compares the results of this second group—call them the ‘risk managers’—with the first. The median investor in this group has a far better outcome simply by reducing volatility. In fact, only 10% of this new group ends up worse off than the original ‘median’ investor. In other words, good risk management can significantly raise your wealth generation potential.
The reasoning behind this is that big losses are extremely tough to recover from. As the saying goes, a 50% loss requires a 100% return to regain. Or as Buffett says, “Rule #1: Never lose money. Rule #2: Never forget Rule #1.”
Now, clearly investing in the real world is a lot more complex than in this example, but there are still lessons that investors can apply. In particular, it’s not that investors should avoid risk altogether—it’s essential if you wish to compound your investments over time—but rather that no amount of skill or patience matters if you get wiped out from excess risk taking driven by unrealistic expectations.
This is all the more important in the current market environment, where gradually reversing trends around interest rates and inflation means the range of outcomes is unusually wide and increasingly difficult to manage.
The last 10 or so years were truly exceptional, but they are not the norm. Future returns may be lower if history is any guide, but by reframing expectations on risk and returns and making incremental adjustments as a long-term investor, the next 10 years might be better than expected.
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