Many people think that to earn more money, they need to take on more risks of capital loss. That is not true. The key to gaining wealth is first and foremost to minimize capital loss, then, only when the risks of capital loss have been minimized, to maximize gain. Why? Because the effect of capital loss is a lot worse than most people think - it will affect your wealth in two ways: by decrease your wealth significantly in the present, and by exponentially decreasing your future wealth.
The immediate effect of capital loss
Imagine you have an investment, where the value rose by 80%, then lost 50% before you sold the investment. How much did you gain or lose? If you think you gained 30%, think again. Let us set the starting value to be $100. After a gain of 80%, the value will be $180. A 50% loss will leave you with $90 - a 10% loss! As you can see, the loss of capital will affect your wealth much more than gain of capital. A loss can take away all the gains you worked so hard for, and more.
The future effect of capital loss
For every $1 you save and invest now, assuming an annual rate of return of 8%, will turn into $10 in 30 years (with $4 present value purchasing power, assuming an inflation rate of 3% p.a.). So for every dollar that you lose now, you are losing exponentially more when you consider its future value (in our scenario, 10 times in absolute value, 4 times in purchasing power). So, not only will capital loss affect your wealth now, it will affect your future wealth exponentially!
"Rule no. 1: Never lose money. Rule no. 2: Never forget rule no. 1." - Warren Buffett (allegedly, but I cannot pinpoint exactly when or where did he say or write this).
If you think about the basic principles in earlier posts, they are all designed to minimize capital loss:
- Pay yourself first - Minimize capital loss to tax (using tax-advantaged retirement accounts).
- Minimize expenses (revisited) - Minimize capital loss to your living expenses.
- Eliminate debt - Minimize capital loss to interest expenses and minimize the risks of losing capital/assets to creditors.
- Build an emergency cash reserve - Minimize the risk that you will realize a capital loss for your retirement fund in an emergency.
By minimizing both capital loss and the risks of capital loss, you will have a higher probability of accumulating significant amount of wealth and gaining financial independence over time. (Disclaimer: No matter how you minimize the risks of capital loss, an unlucky and untimely "black swan" event may still wipe you out.)
Related posts:
- Eliminate debt.
- Minimize expenses.
- Minimize expenses (revisited).
- Accelerate wealth accumulation.
- Maximizing the power of compounding.
## This post is part of "The Principles of Wealth Accumulation" series on this blog.
P.S. This post was featured in 83rd Edition of the Festival of Stocks at Fat Pitch Financials.
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