When making an investment or trade in the financial markets, we tend to focus on potential gains rather than dwelling on potential losses. In other words, we expect our investment/trade to be successful. It is perfectly natural. Otherwise, we would not commit our capital to investing/trading.  

However, we are often so confident and convinced that a particular investment or trade will be profitable, that we do not consider much or pay no attention to the well possible outcome of a loss. Losing money is inevitable, an inherent part of participating in the markets. 

Catastrophic losses can quickly shrink an account to such an extreme, negative value that the possibility of ever attaining profitability becomes a distant reality. Proper control of those losses eventually determines our success and allows us to continue to invest or trade. Money management helps us to minimize the risk (pain) of a loss and enables us to maximize the reward (pleasure) of a gain. 

In investing/trading, the most important lesson is as follows: The percent gain needed to recover a loss increases exponentially or geometrically with the loss.

The table and chart below illustrate what percentage gain is required to recover from a previous loss. As can be seen, the gain needed grows exponentially as the loss increases.

RECOVERY TABLE

For example, if one loses 20 percent of his or her capital, he or she must make a subsequent 25 percent gain on the balance to get even. If he loses 40 percent, it will take a 66.67% gain to recoup, and if she loses 60 percent, it requires a 150% gain to recover the loss.

By taking the quotient or ratio of the loss and gain numbers, we get the exponential or growth factor. For instance, an 80% loss needs a five-fold gain, or a 5 times multiple (80×5), to return to breakeven. 

The final column shows how much percentage gain is required for each additional one percentage point loss. So going from, let´s say, a 10% loss to an 11% loss requires a 1.23 percentage points additional gain – or a total of 12.23% – to compensate for the prior loss.

RECOVERY CHART

The mathematics of gains and losses demonstrates that it is far easier to lose money than it is to make money. Limiting the losses or ‘drawdowns’, and thus preserving the capital, is of utmost importance. In the end, it all comes down to cutting losses short and letting profits run.