Having your money earn more money for you is the name of the game in the stock market. Stock market 101 teaches us that impact of compounding interest is very powerful especially when your money is in the pool longer. When we take a huge draw down (loss) in our portfolio that money is no longer available to earn money for us.
Your ability to earn money in the stock market comes from percent changes not straight dollar amounts. Therefore a small change down in your bigger portfolio takes a bigger percent change to gain back. The most common example of this which is real for many of us who lost large amounts in are 401ks in the recent recession is that a 50% loss requires a 100% increase just to get to even again. Just to see that in real numbers, if you have $10,000 and lose half you now have $5,000. In order to get to $10,000 again you have to earn $5,000 more or double your money.
The stock market on average earns 8 – 10% per year on a long term buy and hold. The rule of 72 tells us that at 10% per year it will take 7.2 years to recover your money. (The rule of 72 is simply taking 72 and dividing by your annual return to get how many years it will take to double your money.) So basically for us long term investors we can expect 7 years to fully recover our money. That hurts for those of us who were planning on retiring soon.
Because of this non-proportional effort to recover from stock losses we need to learn stock market techniques for preventing drops. One of these techniques is stop losses which prevent us from losing any more than a certain amount. Another is using shorts and puts which earn you money when the stock market is falling to offset your other losses. Combining advanced techniques with your traditional investing can really boost your returns while reducing your exposure to risk.