| Successful investing is all about the effective | | | | inside the mathematics of compounding just a bit. |
| management of risk. Managing risk and avoiding large | | | | There we will find out what really makes |
| losses can have a tremendous impact on the growth | | | | compounding work and it will help us understand why |
| rate of your investment portfolio over the long term. | | | | managing risk is so important. |
| Your financial advisor may be telling you that to be a | | | | Losses Reduce the “Earning Balance” |
| “growth investor”, you need to increase | | | | What is the connection between losses and |
| your tolerance for risk and be willing to live with | | | | compounding? It’s simple really. When you lose |
| portfolio losses on the order of 30% or more when | | | | money in your investment account, you reduce the |
| the market goes down. | | | | earning balance. |
| But to really super-charge your long term investment | | | | • It’s the opposite of what happens |
| returns, your tolerance for risk should probably be | | | | when you reinvest your earnings. |
| less than you think … | | | | The mathematical power behind compounding is |
| The point of this article is to understand how risk and | | | | … the steady growth of your earning balance. |
| losses affect the rate of growth in your | | | | When you reinvest earnings, you provide a larger |
| portfolio… and what that means for the risk | | | | investment balance upon which to earn a return. And |
| tolerance you should have. If you are a | | | | here is the key mathematically: |
| “growth investor”, then you need to | | | | Your returns are more sensitive to the SIZE of your |
| understand this basic principal. | | | | earning balance than the size of the investment |
| Doesn’t Growth Investing Mean Taking More | | | | return in any given year. |
| Risk? Our ideas may conflict with what you think you | | | | Size Matters: If you start with $100 and lose 10%, |
| already know about “growth” investing. | | | | you are left with $90. If you earn 15% in the next |
| You probably know that “growth” type | | | | year, you will make back $13.50 and have an ending |
| investments are riskier, so how can you keep your | | | | balance of $103.50. Alternatively, if you started with |
| risk tolerance at a low level and also invest in these | | | | $100 and lost 50% instead, you would have reduced |
| riskier growth investments? | | | | your earning balance to only $50. If you then made |
| We are here to tell you that too much risk will hurt | | | | the same 15% during the next year, you would |
| your long-term growth prospects. By using new, | | | | make only $7.50, rather than $13.50 and end up with |
| more advanced forms of active investment | | | | a balance of only $57.50. |
| management based upon market timing, a growth | | | | Losses Destroy Principal Which Must Then Be |
| investor can reap the benefits of investing in | | | | Replaced. But here is the key “math” |
| growth-type investments and also keep their risk | | | | thing to understand: the reduced principal, or earning |
| tolerance at a low level. | | | | balance, makes it harder to earn the money back |
| This new approach allows you to harness the power | | | | and replace what you lost. |
| of compounding, capture the superior gains of | | | | You can look at the problem this way: If you lose |
| growth investments and multiply profits on top of | | | | 10%, it will take a gain of 11.1% to get back to |
| profits – accelerating the growth of your nest | | | | “break-even”. However, if you lose |
| egg with relative safety. | | | | 50%, it will take a gain of 100% to get back to even. |
| If you don’t think you could learn how to | | | | It is much easier to earn an 11% return than 100%. |
| apply a more advanced approach to your investing, | | | | • When you lose a large percent of your |
| don’t worry. There are various investment | | | | portfolio … you have lost the power of |
| newsletters and advisory services that will simply tell | | | | compounding for multiple years and significantly |
| you what to do. Alternatively, there are money | | | | reduced the long-term result you can achieve. |
| managers you can hire that use the new, advanced | | | | So the point of effective risk management is to |
| techniques. | | | | avoid the big losses. |
| Compounding Earnings Creates the Magic | | | | Increase Your Upside With a Lower Risk Tolerance |
| You can read entire books on how to use the | | | | So what are these advanced investment methods |
| “magic of compounding” to get rich. You | | | | that can allow you to invest in riskier |
| can become a millionaire by putting away a moderate | | | | “growth” type investments while |
| amount of savings for 30, 40 or 50 years, investing | | | | avoiding very much risk to your portfolio? |
| the money at some moderate level of interest rate, | | | | They are active portfolio management strategies |
| and reinvesting the earnings in each period. | | | | that use various market timing techniques to get you |
| The books always point out that the key to the | | | | in and out of different investments. Many of these |
| “magic” is reinvestment. Rather than | | | | methods use computerized statistical models that |
| spend the interest you earn, reinvest the earnings | | | | identify longer-term market trends. They don’t |
| back into the same investment. In each period, your | | | | try to “crystal gaze” the future. They |
| earning investment balance goes up by the amount | | | | simply statistically identify market trends and tell you |
| of earnings in the previous period. Because the | | | | when to get in or out. |
| earning balance goes up each period, you earn more | | | | By knowing when to get out before your investment |
| interest in each successive period. | | | | gets slammed, the active portfolio management |
| • This power of multiplication will start to | | | | techniques significantly reduce risk. |
| accelerate your portfolio growth from period to | | | | In effect, they allow you to include riskier |
| period and lead to a much larger investment balance | | | | “growth” type investments without |
| than if you hadn’t been reinvesting. | | | | having to suffer the inevitable penalty of high |
| To make the connection between your risk tolerance | | | | volatility and steep losses during “bear |
| and the power of compounding, we need to look | | | | markets”. |