“With great powers comes great responsibility” – Uncle Ben (a Spiderman quote)
Over the years, I’ve had countless people ask me why they shouldn’t just buy a triple leveraged index ETF and hold it forever. They look at the performance over the last few years and assume if a leveraged ETF is good to hold for a few days or weeks, holding it for months and years would be even better. Hard to argue with that logic, especially since UPRO and SPXL have performed so well over the last few years.
Well, the answer comes down to basic arithmetic, and more specifically, the property that losses loom larger than gains. The simplest way of describing this phenomenon is with an example.
A 50% gain and a 50% loss start out the same.
Let’s start with $100.
A 50% gain on $100 gives us $150.
On the other side, a 50% loss leaves us with $50.
Plus $50 and minus $50. Sounds like the same thing to me.
But this first step is not where the problem arises. What happens after this first trade is where math bites us in the butt.
Let’s say we want to erase that 50% loss with a 50% gain. Sounds reasonable.
A 50% gain on our leftover $50 gives us $75……hey, wait a minute. Are you meaning to tell me a 50% loss cannot be recovered from with a 50% gain? Yep, that’s exactly what I’m telling you. A 50% loss requires a 100% gain to breakeven.
The above example demonstrates just how critical it is to avoid large losses in the market. If the losses get too great, we might never be able to recover from them. For example, a 90% loss requires a 1,000% gain to break-even. I don’t know about you, but 1,000% gains are exceedingly difficult to come by.