Embrace Losses To Win Big

Investing is about winning isn't it? Return on your hard-earned money. Winning trades. Gaining wealth. Securing your financial future.

Why then should a good investor embrace losses?

Because losses are a simple fact of successful investing.

It's possible to limit losses and manage losses. But losses will come, they come frequently, and they should make you think about your investments and the strategies you use.

If investing was risk-free, there would be no material return to investing over the long term. It's exactly why housing is so dangerous right now. When the prevailing wisdom on the street is that a particular asset will only go up, it tends to be an ominous signal that it will go down.

But I'm not going to talk about housing again. Let's discuss losses and loss management in your investment portfolio.

Investing With Your Acceptable Risk in Mind

To invest successfully, you must understand risk and reward when it comes to investing. It's important to understand your own tolerance for losing money investing. With this knowledge, you can design an investment strategy that works for you.

Risk = Reward

To say that risk corresponds to rewards is not accurate. If this were the case, we would all invest in penny stock mining companies and be millionaires.

It's safe to say that generally riskier assets provide generally higher returns. Stocks return more than bonds, bonds return more than savings accounts, savings accounts return more than cash under the mattress.

There are a few assets which are virtually risk free: short-term government bonds, GICs at a major Canadian bank, a savings account at a major bank, and floating rate government bonds.

However, the return on these assets are pathetic. If you're lucky, you can match the rate of inflation (1.5% right now). This means you are investing to limit losses on the value of your money.

But that's not really investing is it? We invest to grow the value of our money: the reward.

The only way to do that is by taking on risk. And risk in this sense implies the possibility of losing money.

However, a key component of realizing better returns over long periods is risk management. This is because market cycles can be long and losses can kill the will of even the most disciplined investors.

Willingness to take big losses is what separates successful investors like Warren Buffett and Stan Druckenmiller from the rest of the herd.

The reason for this is the disastrous effect of large drawdowns. If an investment loses 50%, it takes a 100% return to recover the loss. If it loses 80%, you must make back 400% to recover the loss.

Take a look at this comparison of the Nasdaq 100 (blue) vs S&P 500 (green) since 1985.

Source: Yahoo! Finance

Clearly, one would have been much better off buying and holding a Nasdaq 100 fund than a S&P 500 fund in the last 3 decades.

But the Nasdaq 100 index fell more than 80% in value from 2000-2002. It took nearly 15 years to recover from that crash!

The more mellow S&P 500 index lost less than 50% in that same crash. It recovered the loss in under 7 years. Even a 50% loss is hard to stomach, but it's much easier than 80%.

Only a 1 in 1,000,000,000 investor would have been able to hold on through that Nasdaq crash. Imagine making spending sacrifices, scraping together money and putting it away, learning about investing, mustering up the courage to take the plunge, and then seeing every $100,000 in your account get relentlessly squished and ground down to a measly $20,000. That is divorce level stuff!

It's much smarter to manage your risk well so you can stay in the game and live to invest another day.

Willingness to Lose

If you can't stand even a small loss, aggressively repay your debts, get a government pension job, stash some cash in GICs, and count on working for 40+ years.

Hopefully the steady salary, pension, CPP, and OAS will translate to a good, risk-free working life and retirement.

If you are willing to lose some money, welcome to investing! This is the way to achieving true freedom on your own terms.

I believe a good way to determine how much you're willing to lose is to really picture it. Think about what your investment account is worth right now. Maybe you're starting out and it's just $10,000. Maybe you've grown that to $50,000 in our current bull market. Maybe you're at $500,000. It doesn't matter because it's all relative.

Close your eyes and get in your own zone. Then, really imagine that number starting to drop. Think about your behaviour and actions surrounding that drop.

When will you get a bit nervous? At what point are you going to tell your life partner? What will they say? At what point will you not tell them because you're afraid to? When will you believe it was all for nothing? At what point will you feel like you FAILED?

For myself, I will get a bit nervous once I lose about 20% of my portfolio. That's a year's worth of hard saving and my expected yearly return gone. I tell my wife everything, so I'm not worried about that. I will likely believe I've made some serious investment fails when my portfolio loses about 50% of it's value.

While no one likes to lose any money, I'm quite willing to see a 20% investment loss. To me, that's just a cost of doing business. I'll accept up to a 50% loss without doing anything stupid, albeit grudgingly. But I am realistically not willing to lose more than 50% of my money in the market.

Using Your Loss Tolerance to Design Your Investments

"Lazy Investing" (Buy and Hold)

It's quite easy to design loss tolerance with a buy-and-hold portfolio. I discuss it in-depth in the growth portfolio article. The important part is balancing your growth components (diversified stock ETFs) with protection components (bonds and gold ETFs).

Diversified cross-national stocks—measured by the MSCI World Index (CAD)—have an expected maximum drop of around 45%. Maybe a bit less with dividends.

Government bonds—especially short-term bonds—have an expected maximum drop of 5% or less. However, bonds tend to go up when stocks fall so it can act as an offset rather than a compounding problem.

By combining these factors, it's easy to design a portfolio that is matched to your risk. The formula is: Loss % = [% stock x (1-0.45) + % bonds] - 1.

If you can lose 20% before hitting the fail point, than you would have no more than ~40% diversified stocks. If you can lose 40%, than you can have up to 90% diversified stocks. Re-balancing and regular contributions can help manage the losses as well.

Dual Momentum Strategy

It can be more difficult to determine max loss scenarios using the Dual Momentum strategy. Gary Antonacci's work using a 12-month lookback suggested the maximum drawdown over the past 45 years was just under 20% in U.S. dollar terms. History is a good guide!

To get an idea of what a 20% drawdown looks like, just follow the blue line in this chart. Some significant drawdowns occurred in 1987 and 2007.

Source: DualMomentum.net

Because the strategy limits losses to the lookback period, it's very unlikely the loss in Canadian dollar terms would be much different. G. Grewal posted foreign investor results using several different methods on Antonacci's blog a few years ago. His analysis showed results are similar, if not better, in Canadian dollar terms.

To be on the cautious side of things, I would not use Dual Momentum if you can't stomach a 30% drawdown. Dual Momentum is a strict rule-based investment approach; deviation from the rules will not serve you well.

I would also say that my method of using an average of the 12-month and 6-month lookback is likely to further reduce drawdowns when compared to a simple 12-month lookback.

Trend Investing

To manage loss with trend investing one must manage position size, set loss limits, and very strictly follow rules to remove emotionally-driven mistakes.

Since I can tolerate a loss up to 50%, there's a lot of room to work with. To be on the safe side, I've set up my trading to tolerate a 20% medium-term loss scenario (my nervous point).

First, I limit my position size to a maximum of 20% of my total portfolio value (except S&P 500 and EAFE indices). Second, I will always enter a position with 10% of my portfolio on the first entry signal. This means my first buy is always a half-position to test the trend.

Third, I limit my loss on purchase to a max of 10% of the position. If the trend turned within days after purchase—as it most often does in these cases—I will happily cut my loss at 1% of equity and get out of the position quick.

This means that each position from the initial purchase will only affect 1% of my total portfolio value (10% position with a 10% max loss).

If I enter 10 new positions at the same time (very unlikely), I would still be exposed to just a maximum 10% loss of my total portfolio based on my rules.

With trend investing, I can bet on the market going up or down. This means I can take positions that a normal investor wouldn't take.

For example, I can have a 20% position betting the S&P/TSX Index going up while at the same time having a 20% position betting the NASDAQ 100 Index goes down.

Taking trades that bet on different markets taking different directions is all based on the trend of each individual market. It doesn't matter to me which market moves which way when, I just wait for the signal to make the trade.

There's also a fail safe that everyone can take. If I make multiple trades in a short period of time which all take a 10% loss on each position adding up to 20% of my total portfolio, well it might be time to take a break.

I can always leave my accounts in cash for a few weeks, or if I really need to clear my head I can dump everything in short-term bonds for a few months and walk away knowing the money will be there when I come back.

Your Investing

I can't tell you how you should invest. The strategy you use, the risk tolerance you embrace, the positions you buy, how much you save... these are factors in your control only.

I'm here to share my story and hopefully you can use my knowledge to avoid making big mistakes. Self-directed investing is a big step—a leap of faith in your own abilities—and it's important to get the details right.

Investing is not easy, but with proper risk management you can win big and stay in the game for decades. Acceptance of risk is the only way to achieve true financial freedom.

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We Moved! And Renting Still Beats Buying

Edited Photo. Source: Realtor.ca

Check out our new house! A few months ago I outlined some of my own goals for the coming years. I like to practice what I preach, so we've downsized again.

It's our second move in as many years. I'm admittedly a bit tired of moving at this point, so I locked in a longer-term lease.

Once again, we got rid of a lot of crap in the moving process and would say we are well on our way to minimalism. There are very few things left in our possession which we have not actually used or received meaningful benefit from in the past year.

Our first house was a massive. We bought a fixer-upper a few years ago, did a complete renovation, and eventually sold it for next to zero profit—even in a slightly rising house market. That house was a 1970s split entry with 2,000+ sq.ft. finished area. I estimate our wage rate on all the hours of work we put into the renovations was about $10 per hour. Pitiful considering I'm a journeyman carpenter...

A year ago we moved to a still-too-large-for-us duplex which we rented. (Our first experience renting). It was not ideal and didn't help our vehicle costs or other life costs. But it did get me switched on to the ease of renting. I would estimate that house was approximately 1,500 sq.ft. of finished space plus a full unfinished basement.

Just a few weeks ago, with the help of a few friends, we downsized once again into a 2 bedroom, 2 bath row-house. This place is around 1,100 sq.ft. finished area with a double car garage. The size is just about perfect for us, especially considering we live in a city with 6 months of winter. We spend a fair amount of time indoors during those cold months!

A Financial Evaluation

As shared in a post a long time back, in my former rental duplex I was better off renting than owning by a whopping $400 a month. Twenty-five years down the road, I could reasonably expect to be $250,000 wealthier renting that duplex vs. plunging into ownership.

Once again, I did some calculations before deciding to rent our new townhouse. Ownership is always an option, so it should be considered.

Let's do some Moose Math to figure this one out.

Owning

Purchase Price: $320,000
Downpayment: $64,000
Mortgage @ 3%: $1,210/month
Exterior Maintenance/Condo Fee: $280/month
Interior Maintenance Est: $100/month
Insurance: $75/month
Property Tax: $190/month
Total Ownership Cost:  $1,855 during mortgage, or $645 after mortgage is paid off

Renting

Rental Fee: $1,550/month
Insurance: $25/month
Total Rental Cost: $1,575

Required Savings: $1,575 (rent) - $645 (ongoing ownership costs) = $930 x 12 months x 25x Rule = $279,000 Savings Requirement
Downpayment Future Value: $64,000 (1.06^25) = $274,700
Compound Interest on Monthly Difference: $1,855 - $1,575 = $280 [(1.005^300)-1)/0.005] = $194,000
Total Future Value in 25 Years for Renting: $468,700

Simply put, in this evaluation I could choose between fulling owning a mortgage free $320,000 townhouse in 25 years, or having a $468,700 investment account. (All in today's dollars).

Naturally we chose renting once again. I firmly believe most renters who invest will be better off than homeowners in the coming decades.

I'll also mention that our former home equity has grown substantially in the past year of renting. At this point the investment gains alone will pay for several years of rent fees.

Based on my math, our former home equity has grown to the point where it will easily cover the net rent costs (Rent Fee - Ongoing Ownership Costs) for the rest of our lives using a 25x Rule.

Investing the downpayment and rent cash flow difference is a key factor here. The fact that house prices are absurdly high in many parts of Canada just makes this an easier win for renters.

Of course, some would say that I'm discounting the outsized historical return of housing, forgetting the leveraged return aspect of homeownership, or just that stocks are "riskier" than houses.

Well let's dig into some of these commonly held beliefs.

Housing Historical Return

Housing in Canada has been on a tear since the 1980s. You shouldn't be surprised about this. But don't kid yourself, it's not a coincidence and it's not a "new normal".

In the past decades, interest rates on mortgages have dropped from 20% to just 2.5%. This has made the cost of borrowing for housing cheaper. Yet, as a percentage of our income, we are spending more on our housing now than we did back then.

In the 1980s, the typical Canadian family spent 20% of their gross household income on mortgage payments. Today that number is more than 26% of gross income. Considering nearly 30% of our incomes get sucked up in income taxes, this is huge!

Lower interest costs plus higher spending as a portion of income means a huge boost in the value of the underlying asset—your house. This can give the illusion that housing is a good investment. But most economists disagree.

It's more likely that we've hit the "max" amount of our household budget that can be spent on mortgage costs and we've also hit the realistic low of mortgage rates. I believe house prices are only likely to go down relative to income from this point.

Already there is substantial evidence the Toronto market is collapsing. From a price peak early this spring, detached house prices have fallen as much as 20%! There's a lot of home equity being wiped out there.

Pretty much everyone who bought a house in the GTA in the past year is in a negative return situation after selling costs now. As our country's largest market by far, this can set the trend for the whole country.

Over very long periods of time, it's generally accepted that housing returns are comparable to the inflation rate. This is expected since inflation rates and wage rates go hand-in-hand.

Leveraged Returns

Housing in Canada is a highly leveraged asset. With at least $1.35 Trillion in mortgage debt alone—nearly the size of Canada's entire economic output in one year—it's apparent that houses and debt go hand in hand.

High leverage can make gains seem great, but losses really really hurt. When buying with a 5% downpayment, your leverage ratio is 19:1 (you borrow $19 for every $1 you put in). This means you realize a magnified gain or loss compared to the base asset.

To put this into realer numbers, take a $500,000 house and you put down 5% ($25,000). If the price of the house goes up 10%, your return on equity is actually 200%. If the house price goes down 10%, your return on equity is -200%. Closing costs not included. A -100% return means your equity is gone, more than that means you owe more than the asset is worth.

In housing, because of the structure of mortgage pay down, your leverage ratio declines over time. This means that a 10% gain in house prices during the first year after purchasing looks a hell of a lot better than a 10% gain 20 years after purchasing. Likewise, a 10% loss in value is much more damaging in the first years after homeownership.

One way to maintain leverage rates at a reasonable 65%, diversify your assets with some real investments, and be on the right side of the tax equation is to use the Smith Manoeuvre.

It's important to remember that leverage works both ways. It looks really smart when your asset goes up in value, but should be avoided when prices are flat or going down. A lot of investors who appear very successful in rising markets get wiped out by taking on too much leverage.

Risk In Housing

Risk can be measured in many ways. One method is to evaluate loss. In the U.S., during their housing crash of 2006-2012, house prices collapsed nearly 40% nationwide.

In the most overheated housing markets of Florida, California, Nevada, and Arizona, house prices fell as much as 70%. That would be devastating, but it's not out of the realm of possibility. What happened before can happen again. A 70% skid would see detached Toronto homes under $500,000 in the future.

A passive stock-bond portfolio can see a drop up to 50%. If you invest following the Dual Momentum strategy, your max loss is about 20%. Depending on your indicators and limits use, your max loss with trading rules can be less than that still.

The worst market conditions in history during the Great Depression, and not even globally diversified, saw a 70% drop in U.S. stocks.

In my view, housing is roughly as risky as a properly invested stock portfolio. Don't over-leverage, don't assume its not risky just because it's a roof over your head, and certainly don't believe housing prices never suffer from severe corrections.

Comments & Questions

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