From the Bottom Up

Let’s say that you put \$5,000 a year into an IRA account (the maximum amount allowed in 2010 for people who are 49 years old or younger) every year on September 1. You earn a 9% return annually (which is what the US stock market averages). So, the first year you’ll have \$5000 in your account and on the second September 1 you’ll have \$10,450 (your original \$5000, plus the \$5000 you added that day, plus the \$450 you earned in interest over the previous year). If you keep that up for 25 years, in the last year you’ll have almost \$425,000.

But then suppose that over the next year (the 26th year) the stock market drops 30% – the same as from a level of 14,000 to 10,000 (as the Dow has done over the past year or so). Your account will go from just under \$425,000 down to just over \$300,000 – a loss of over \$120,000. For perspective, keep in mind that you put in \$5,000 a year for 25 years, so \$125,000 is the total amount you have contributed in the life of the account.

One way to think about the stock market dropping from 14,000 to 10,000 is that you have lost 30% of your money – a deep cut.

Another way to think about it is that it has wiped out almost every penny you put into the account over the past 25 years.

But there’s another way to think about having \$300,000 in an account to which you have contributed \$125,000 and that’s that, despite the 30% drop the previous year, you still have more-than-doubled your money. You put in \$125,000 over the years, but still have just over \$300,000.

I think the lesson here is: Don’t compare the current level of an investment account to its value at its absolute peak. Of course your performance will be down from that perspective. Compare your performance instead to your cost basis – that is, the value that you personally have contributed over time.

I think this lesson applies to all sorts of investments of blood, sweat, money and tears over time, not just stocks.