By: Dividend Sensei
When the housing bubble burst AIGFP suddenly found itself with $20 billion in losses, (which eventually became $110 billion), and AIG itself was liable for that. The problem was that AIG couldn’t afford that kind of loss. And since AIG was one of the world’s largest insurance companies, with dozens of different policy types made out to millions of people and businesses, it threatened to trigger a cascade failure throughout the entire global financial system.
Or to put it another way AIGFP and its dangerous policies made AIG too big too fail. So the US government bailout of AIG to the tune of $150 billion when it was all said and done. Now AIG survived and never went bankrupt. However the bailout required AIG to dilute investors nearly 13 fold, which is why AIG’s stock is now down 96.9% from its all time high. Keep in mind the company is still highly profitable, (excluding a one time tax reform charge), pays a dividend and analysts expect its EPS to grow at around 11% annually over the next 10 years. But if you bought AIG at the top? Well then you are still a 3200% increase away from breaking even.
These are some extreme examples of how buy and hold investing can go terribly wrong with your money evaporating and never coming back, at least not likely within your lifetime. But my point is that these are true losses, because the investment thesis broke. These are not the kind of short-term declines that are common in the stock market and what most people fixate on.
If your portfolio declines by 1%, 2%, even 5% in a day? That doesn’t matter because the chances that a well diversified portfolio, (or a broad based index fund’s), thesis has been permanently shattered is very low. In other words understand that while some companies do fail, (it’s the nature of capitalism), 99% of the time a share price decline is meaningless. It’s a short-term phenomenon that will likely revert to the market’s natural path, which is to rise on an annual basis 70% of the time.
Which basically means that rule 1 is to understand the difference between real risk, (permanent loss of capital from a shattered investment thesis), and temporary paper losses. In my next article I’ll explain rule two, which is one of the most essential components of risk management, and in fact of investing and life in general.