An ARKK-typical problem*

The year 2022 is drawing to a close, and many investors are sitting on some steep losses. The losses are so big that psychologically, some investors may be unwilling to accept them and remain invested in assets that have suffered extreme losses instead of selling them and moving on to other investments. Investors in Cathy Wood’s ARKK Innovation fund or cryptocurrencies come to mind. But trying to wait it out may be an even bigger mistake than investing in these assets at the wrong time in the first place.

The problem for many investors is that they have a hard time understanding the impact of compound investing. Compound investing is often shown as the driving force of returns in the long run, but compound investing also has a darker side. It compounds losses as well.

Assume for a moment you are as old as I am, and you made your first investment on 1 January 2000. The tech bubble was in full swing and you decided to invest in the high-flying tech stocks of the day. So you buy a fund that tracks the Nasdaq Composite instead of the old-fashioned S&P 500 (let’s ignore that index trackers weren’t really a thing back then…). The chart below shows how your Nasdaq investment fared compared to the S&P 500.

S&P 500 and Nasdaq after 2000

Source: Bloomberg

At the end of 2000, your would have lost 40% with your investments compared to a 10% loss for the S&P 500. But what is worse, it would have taken you 13 years until December 2013 to recover your losses and get back to where you started. Investing in the S&P 500 would have not only given you smaller losses but a quicker time to recover and by the end of 2013, an investment in the S&P 500 would have been up 25.3%. That’s not a great return over 13 years, but by sticking with the Nasdaq, investors have effectively reduced their wealth by one quarter.

Now fast forward to 2022 and have a look at the many popular investments of the last couple of years. Cathy Wood’s ARKK Innovation Fund is down 62.6% year-to-date, Bitcoin is down 63.9% and if you happen to be an investor in FTX you are down 100%. Meanwhile, the S&P 500 and the Nasdaq didn’t have a great year either, but they are down 16% and 28.7%, respectively.

Returns in 2022 year-to-date

Source: Bloomberg

My question to all these investors in ARKK, Bitcoin, etc. is the following: Are you going to stick with these investments in the hope of recovering your losses or are you going to sell them and move into the S&P 500 or other investments?

Judging by the conversations on Twitter, my guess is that the people who believe in Cathy Wood, Elon Musk, cryptocurrencies, etc. will not abandon these investments. Instead, they will hang on to their belief in high returns and a quick path to recover their losses and then on to infinity and beyond.

Unfortunately, that would be a mistake that compounds the losses of 2022. In the table below I have done a little bit of maths to show you why. I assume that an investment in the S&P 500 will average 10% per year from now on (I know, it’s a brave assumption, but bear with me). Meanwhile, I assume that the Nasdaq, the ARKK Innovation Fund, Bitcoin, etc. will all have an average annual return that is twice as high as the S&P 500, ie 20% per year.

Some people may say that is underestimating the returns of ARKK, Bitcoin and Co. but I would say you can be lucky if you get anywhere near these returns. What we have seen in the last five years was a bubble in these assets of epic proportions and history tells us that in the aftermath of these bubbles it takes years for returns to recover to levels that are even close to average equity market returns, let alone outpace them by a factor of two. In the aftermath of the tech bubble in 2000, the Nasdaq was underperforming the S&P 500 for eight years. In the aftermath of the financial crisis, banks underperformed the S&P 500 for seven years until 2016.

But even if ARKK, Bitcoin and co. can provide stellar returns of 20% per year, it will take investors 5 to 6 years to recover their losses. By that time, the S&P 500 will be up more than 40%.

Time to recover losses

Source: Liberum

So, while young investors will be trying to get out of the massive hole they have put themselves in over the last year, more conservative investors will be laughing all the way to the bank. Of course, nothing can be done about past mistakes, but there are two lessons for investors to learn, just like I learned them after the tech bubble in the early 2000s:

  1. Investing in highly volatile assets is not just dangerous in the short term. Once you are in a hole, this volatility will put you at a disadvantage for years, if not decades in the future. What matters for the long-term is not returns, but the ratio of returns to volatility.

  2. Don’t put large amounts of your savings in extremely high return assets. Investments in ARKK, Bitcoin and co. can be worth a punt and a small bet with a little bit of money can’t hurt. But remember they are bets, not investments and more often than not, these bets will go wrong and create big losses.

*With apologies to all linguists for torturing the English languageā€¦

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