Return OF Capital vs. Return ON Capital
“I am more concerned about the return of my money than the return on my money.”
- Mark Twain
(oddly enough)
Bottom Line — The return OF capital is the single most important aspect of investing.
Closely followed by the return ON capital. However, all that gets discussed is the latter of the two, return ON capital. Why is that the case? I’ll explain in more detail later, but first I want to make sure we’re all on the same page with what each of these terms mean.
So, to start, return OF capital talks about your original investment. If you were to deposit $100 in an investment account, then that $100 would be considered your original investment or capital. Therefore, when you invest that $100, return OF capital refers to giving you back your money—or that initial $100.
Now, compare that to return ON capital, and the word “return” takes on a slightly different meaning. Before, it related to giving you back your money, or capital; where here, it means the amount of money you earned on the investment.
For example, let’s say you made 10% on your investment, meaning your account is worth the $100 original investment plus 10% (or $10)—for a total return of $110. When that total amount is “returned” to you, then you receive a $100 for return OF capital, and $10 for return ON capital. Now granted, this is a very basic calculation; but it should still give you a good idea of what these terms represent.
Now that we’ve clarified this, let’s discuss the issues that lie between these important concepts. Because as we listen to financial shows and read various financial newsletters/blogs, they all have a tendency of only talking about how to generate return ON capital; but rarely (if ever) discuss the risk of getting your money back, or the return OF capital.
Return OF Capital
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It has become a foregone conclusion among most experts that you simply “win some and you lose some.” Though, not necessarily wrong, this can quickly become a very dangerous thought process.
What do I mean by that?
It’s clear that investing involves losses. This aspect of investing is simply unavoidable because none of us have the foresight to know what tomorrow holds. However, the fact remains that we must concentrate first and foremost, on protecting our investment or capital; or as stated here—our return OF capital.
Which ultimately brings us to the bigger issue facing today’s market: volatility.
As the market gyrates up and down that is called volatility. Increased volatility, or increased moves (up or down), is risk to the investor; because it risks your ability to get your money back. We don't know when the next market downturn is going to happen; nor do we know how long it will stay down. And the same goes for upturns in the market, but I'm sure you won't find any complaints there.
Unfortunately, the ugly truth of the matter is that you can't have upturns without the downturns. But the real kicker stems from the fact that if it the market downturns at the wrong time, then life goals and life's work can be ruined or put on hold.
For example, think of those set to retire on December 31st, 2008. After decades of work, you finally saved up enough for retirement and set your date. As you get closer, or about five months out, the market is at a near all-time high (at that point in history), and you're feeling great about your investments.
Then, one month later, you watch the market see one of the worst downturns since the great depression—destroying your life's work/savings. And less than 120 days later, you're left with only half of the money you originally set aside.
Now, let's think about this just a bit more.
Because not only did it wipe away the value of your portfolio, but for nearly five years after 2008—you got exactly zero extra money. Essentially, every dollar earned was to help re-build what was lost, for that period. So, it cost nearly five years of life and even more hard work—just to fight to get back what you already had.
Therefore we at Moss Point Financial always say,
“Losses hurt more, than gains help.”
Because had you lost zero money and made zero money in that same time frame, you would have been much better off; than losing 50% and having to regain it over nearly five years—which is what investors were forced to do.
To put this into perspective, 6 months following September of 2008, the market had wiped out ALL your yearly returns, going all the way back to Q2 of 2002.
Simply put, you watched 6 years of hard-fought returns vanish in 6 months.
And to make matters worse, not only did you give up 6 years of returns, but also:
4 years to get back to even
9 years to get back to where you should have been before 2008
& if the market had continued its historical pace (without the 2008 downturn), going into the 2020 pandemic, it would've been ~36% higher with the DOW near 40,000 points
Now, a 2008 move does not come along all that often, so this is a bit of an extreme example (unless you were one of those people set to retire on December 31st, 2008—then it's your unfortunate reality). However, on a historical basis the market corrects by more than 10%, about every 18 months.
Therefore, the downside is far more impactful for investors and financial plans, than the upside. In fact, if you were to remove all the negatives incurred over the years, you would produce returns over 25% higher (over the history of the market).
Thus, the goal should be clear then; reduce losses as much as possible before you try to increase returns on your money. But how?
Return ON Capital
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This brings us to the second issue at hand, which is return ON capital. We always have the choice of saving money by simply placing it in the proverbial mason jar to bury in the backyard. However, I think we all know by now, that this is probably not the best idea.
So, where do we go from here?
The fact is, market volatility requires the investor to not only make money, or return ON capital (on their investments)—but also experience the inevitable losses. This stressful scenario forces most into recovery mode to make up for the lost capital, while actively trying to grow the account at the same time.
In addition, what isn't being considered, is the amount of time you've now lost and will ultimately never get back. This is an important notion to remember, because it severely hinders your ability to successfully build wealth—especially as you begin to approach your prime retirement years.
Further, we know that losses hurt more, than gains help, but we still need to make our money work for us, and we still need a return ON our capital. The problem, though, is that often as investors fall behind in reaching their goals, they typically take on more risk to “make-up” for lost time or lack of return. But this is a fool's game as an increase in risk also increases the chances of loss.
This is almost the same as saying, “since I haven't done well enough in the market, I might as well take my chances and head to the casino to make up for lost ground”... probably not the smartest or most effective strategy for your money.
Therefore, I believe the opposite. I believe in low risk investments, that maintain competitive, market-level returns—where the chances of loss are extremely limited.
These types of investments exist but might be located outside of your comfort zone. Which is why I implore you to think differently as an investor. Because often, comfort zones dis-allow growth, steering investors in the wrong direction; which re-buffs good opportunities and prevents you from reaching investment goals in a safe and timely manner.
All of this is important to think about, especially when building wealth and trying to navigate periods of high uncertainty and market volatility. So, with that, I encourage investors to be smart, portfolio-driven, and to take action in stabilizing financial plans—by utilizing alternative sources that are "disconnected" from the market.
