What will it take to earn your money back?

The terrible market declines of the past year have investors everywhere licking their wounds and toting up their losses, even as they prepare for the possibility of more losses to come. Nearly every portfolio that holds stocks is down significantly since late 2007, with 40% declines not uncommon. Just about the only solace is the thought that the market is bound to turn around at some point, and then people can start making up some of the ground they've lost.

But what, exactly, will it take to make up those losses? Many people underestimate the gains needed to recover from big investment losses, and the extent to which additional losses put you deeper in the hole. Amid all the current market gloom, it's worth taking some time to understand what it might take to recover from the current market swoon.

Climbing out of the hole
Suppose you hold a stock that falls 50% in value. How much does that stock have to gain before you're back where you started? Many people instinctively say 50%, but that's wrong. If the stock's price starts at £10 and loses 50%, it's at £5; from there, gaining 50% would put it only back up to £7.50. To get back to £10, the stock would have to gain 100%, twice as much as it lost in percentage terms.

Recouping losses always requires a larger percentage gain than the loss itself, and the difference between the two gets more dramatic as the losses get larger. For example, as of March 11, British American Tobacco shares had lost 11% over the past year, meaning it will have to gain 12% to recoup that loss. As of the same date, United Utilities had lost 29% over the past year, but it will have to gain 40% to get back to where it was a year ago. HSBC had lost 52%, and it will need to gain 109% to make up those losses.

Once the losses exceed 50%, as they have for many equities, the numbers get even uglier. For example, property developer Hammerson has lost 78% of its value over the past year as of March 11, meaning it would need to more than quadruple in price (gaining 360%) in order to make up for that loss. (If Hammerson gained 78% from this point, shareholders would still be down 62% overall.) No wonder the real estate investment trust is due to leave the FTSE 100 index later today as part of the quarterly review. The numerous stocks that have lost 80% or more over the past year are in much worse shape and are unlikely to get back to where they were in the foreseeable future.

Easing the pain
All this may seem a bit depressing, and it is, but it highlights the importance of diversification. If you had your entire life's savings invested in one of the stocks that have completely imploded, your portfolio would be critically damaged and would be facing a long recovery. But, of course, very few investors have all their money tied up in a single stock, and with good reason; as we've pointed out many times before, diversifying your holdings helps stabilise a portfolio and lessens the chance of one investment torpedoing returns. Even in a market where everything is down, like last year, moderating your losses can make it much easier to bounce back.

The best way of diversifying a stock portfolio is through asset-class diversification. While major stock indices all lost more than 30% in 2008, the FTSE Gilts All Stocks Index gained 12.8% and the BarCap Sterling Aggregate Index rose 4.4%. Of course, many individual bonds and bond funds declined in value last year, but the magnitude of those losses was generally less than for stocks. A portfolio consisting entirely of Fidelity Moneybuilder UK Index, which tracks the FTSE All Share would have lost 30% in 2008, and would need to gain almost 43% to regain that lost ground. Putting 20% of the portfolio in L&G All Stocks Gilt Index Trust would have reduced that loss to 21%, and the percentage needed to make it up would be reduced to 27%. Putting 40% in the bond fund would reduce the portfolio's loss to 13%, which requires only a 15% gain to make up. Losing 13% in a year is certainly not fun, and most investors would have a mix of corporate bonds and gilts in their bond allocation—not just gilts, but our simplified example shows clearly the benefits of diversification.

One very basic rule of thumb for determining a good stock-bond allocation is to subtract your age from 100, which gives a rough estimate of the percentage you should have in stocks. Thus, if you're 50 years old, it's a good idea to have 50% of your portfolio in stocks; if you're 60, it makes sense to have 40% in stocks; and so on. In addition to making sure your portfolio is diversified by asset class, it's also important to ensure that it's spread across different industries and individual securities.

While there's certainly no guarantee that the market will take off any time soon, the potential for sharp upward gains--or perhaps better yet, slow and steady gains over a period of several years--makes it possible that long-term stock investors will not only be able to make up their recent losses but will outpace conservative investments like cash and bonds over time.