A break even analysis doesn’t need to be complicated. It just needs to be realistic.

Successful investors never “go for broke,” as the saying goes. Instead, they try to arrange their portfolios so that they profit more or less automatically over long periods. You do that by tapping into the long-term growth that inevitably comes to well-established companies when they operate in relatively free economies during relatively prosperous years and decades.

New investors should also take the time to understand a simple break even analysis. For example, if you lose X% in the stock market, you’ll need X% to break even. An understanding of this relationship can help you stay out of poor-quality stocks where the risk of a big decline is high.

We feel it’s important for new investors to learn about break even analysis because often rather than avoiding high-risk areas, many beginning investors feel drawn to them. That’s because trouble-prone areas always manage to give some investors the mistaken impression that they can generate big and easy profits. Unfortunately, the risks are even bigger.

When they are just starting out, many investors believe they can afford to take big risks with their money. After all, if they lose money, they have decades to break even. The truth is that new investors overlook the way that a simple break even analysis affects your investment goals. The arithmetic works against you when you take on too much risk.

• If you lose 10%, you need an 11% gain to break even.
• If you lose 20%, you need to make 25% to break even.
• If you lose 40%, you need to make 66.6% to take you back to where you started.
• If you lose 50%, you need a 100% gain to break even.

An 11% gain is relatively common; in fact, the market has gained nearly that much annually, on average, over the past 75 years or so. A 25% gain is a little harder to achieve. You need an above-average year to make that kind of return.

Gains of 66.6% to 100% or more can take years. Even if you make enough money to regain your losses, however, that only brings you back to where you started. You’ve still lost some purchasing power to inflation. But in addition, you’ve lost the time value of your money. You’ve missed out on the compound profit you would have made on your original stake and your profits if you had invested more conservatively and made modest gains of perhaps 5% to 10% annually. That’s why understanding break even analysis early in your investing life can pay off huge returns in the long run.

Of course, even the highest-quality, best-established stocks go down when the general market is falling. The difference is that top-quality stocks tend to recover faster and eventually go on to new highs. Meanwhile, they generally keep paying dividends. Downturns and unexpected stock growth will often prompt new investors to sell prematurely. 

The danger of selling superstocks just when they’re getting started

Experienced investors can tell you that some of their best stock picks started going up out of proportion to what they expected, and kept out-performing for years. By the time the first significant “dip” or setback comes along in a stock like this, it may have tripled.

Remember, no one can predict which stocks will be average performers, which will be losers, and which ones will turn into the superstocks that wind up rising five-fold, 10-fold or more. You may avoid some temporary losses if you sell every stock you own that goes up faster than you guessed. But do that, and you will also sell any superstocks you stumble upon, often when they are just getting started. That could mean that your stock investing strategy never pays off.

Note that our Successful Investor approach, automatically limits your involvement in notoriously trouble-prone areas like new issues, start-up companies and illiquid investments.

Of course, you also need to stay out of companies when you have doubts of any sort about the integrity of insiders. You need to recognize the special risks of investing in fashionable or excessively popular minefields, such as Internet stocks in the late 1990s, or income trusts in the previous decade, or green energy in the current decade, be profitable by using our three-part Successful Investor philosophy:

No matter how you invest for retirement, you should take care to spread your money out across the five main economic sectors: Finance, Utilities, Consumer, Resources & Commodities, and Manufacturing & Industry.

By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion.

You also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average.

Our three-part Successful Investor strategy:

1. Invest mainly in well-established companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Have you underestimated how much you need to recover to break even? Do you use a more detailed break even analysis with your portfolio? Share your experience with us in the comments.