Investing is about achieving returns and managing inevitable periods of loss. A valuable tool to better understand these periods is the drawdown chart.
This chart shows how often and how much a portfolio falls below its all-time high before recovering. Such phases are not only unavoidable but also necessary to realize the long-term growth potential of the markets.
The drawdown chart highlights an essential truth about investing: a portfolio spends most of its time below its all-time high. At first glance, this may seem not very encouraging, but it indicates that there is always potential for growth.
After every decline, there is eventually a rebound, presenting a significant opportunity for long-term investors.
Drawdown chart: why exposure to the time below the all-time high matters
The fact that a portfolio is often below its all-time high is a natural characteristic of financial markets, which fluctuate due to countless factors: economic developments, interest rates, geopolitical events, and more. These fluctuations are normal and unavoidable.
We all know that a 50 percent market crash requires a 100 percent gain to return to the previous high. While such a broad market decline doesn’t occur often, it illustrates the markets’ enormous potential. These drawdown phases are not just inevitable; they are essential for enabling long-term growth.
But that also means I am underwater until we hit this 100 percent gain mark.
Recognizing that my portfolio spends most of its time below its all-time high leads to the key ingredients for a successful investment strategy: patience and a willingness to invest for the long term. Another important dimension often overlooked is the significance of human capital and its impact on the financial journey.
Human capital is the greatest asset in the first half of life
Human capital is the most valuable resource that most people possess, especially in the first half of their lives. It represents the ability to generate income through work, knowledge, and skills.
While mindful investors often look for ways to save money, they commonly miss the aspect of generating a high income. Nevertheless, it is central to financial success and building a financial safety net.
Incomes usually peak in the 40s and 50s, when people reach the height of their careers. During this period, human capital generates a rich and stable cash flow, enabling people to live well, enjoy life, and also save and invest.
“When I started my career as a lawyer in a big law firm at the age of 29, my human capital paid off. My monthly salary exploded and for the first time in my life, I didn’t have to keep one eye on my bank account all the time. My annual salary as an Associate in a Big Law firm was in six figures and I was able to save a decent amount every month, which I immediately put into my depot.”
However, the value of human capital diminishes over time, typically declining in the latter half of life. Yet, it remains a crucial part of a financial strategy. A young graduate, for example, is often seen as having a higher “value” due to greater future earning potential than someone in their 50s. In later life stages, other asset classes come into focus.
Warren Buffett is a prime example of this transition, having earned most of his wealth after turning 50. This illustrates that while human capital loses market value with age, the returns from earlier investments can grow exponentially.
Time as a driving force and the power of compound interest
Time is a complex concept and the driving force behind everything. It is equally available to everyone, making it a fair resource. Unlike other resources, time cannot be shortened or extended; it must be used wisely to achieve desired outcomes.
The power of compound interest
Compound interest combined with high income exemplifies how time becomes an investor’s greatest ally. Although exponential growth is difficult to grasp, it can be achieved through compound interest. Small investments made over a long period can yield enormous returns. The earlier you start and the larger the initial investment, the greater the impact. Leveraging time is crucial for long-term investors.
Investing in human capital
A common mistake many investors make is neglecting investments in their human capital. Instead of investing in themselves—such as through education—they invest all their money in stocks, ignoring the potential of their own skills. Yet, human capital’s “market capitalization” is often much greater than their portfolios. Investing in one’s knowledge and abilities can yield higher financial returns than a comparable investment in the stock market.
In the first half of life, the priority should be maximizing human capital to build a strong financial foundation and create a basis for passive income through dividends. This reduces dependency on labor over the long term and allows an earlier focus on generating returns from passive income sources.
Utilizing time as an ally: long-term strategies for financial security
Knowing that markets spend most of their time below their all-time highs leads to important investment strategies: it is always wise to have free capital available to invest when markets are under pressure. A recurring inflow of cash via dividends or a salary is the best way to ensure such a never ending flow of liquidity.
Equally important is maximizing human capital to grow the cash flow stream through salary to a strong liquidity river. Balancing active investment in oneself with passive investment in the markets can provide the best foundation for long-term financial success.
By continually investing in personal development while strategically investing in the markets during downturns, one maximizes the chances for high returns. The greatest challenge often lies in having the courage to invest in the most challenging times.
Finding the balance between human capital and market opportunities
Ultimately, investing is not just about stocks and markets but the intelligent use of most people’s greatest asset – their human capital. Maximizing this capital early and consciously is crucial for long-term financial health. The key to sustainable wealth and financial security is the ability to seize opportunities during the toughest times while fully utilizing one’s human capital.
By making wise investments and strategically using their time and resources, investors can benefit from both worlds: market returns and the rewards of their own talents and abilities. This means that the financial journey is not only determined by the markets but also by the decisions each individual makes to maximize their human capital and turn it into financial success.
Your drawdown chart goes south: first comes the pain, then the payoff
Of course, it hurts when your portfolio is deeply in the red and your drawdown chart goes south. But that’s part of the game. The key is enduring the uncertainty of these times and investing strategically to set the stage for long-term success.
By consistently generating cash and investing it when markets are under pressure, I aim to maximize returns through market dynamics. It is straightforward yet challenging; the most significant hurdle is having the courage to invest in the most difficult times, but that is precisely where the key to lasting wealth lies.
