Embrace Losses To Win Big

Edited Photo. Source: Flickr - Peter Harrison

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 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.

If investing was risk free, there would be no material return to investing. 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 we're due for a correction.

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 miners 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 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 losing money.

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

Willingness to take big losses is what separates 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 debt, get a government pension job, stash some cash in GICs, and count on working for 40+ years instead.

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 failed 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 - such as MSCI World Index (CAD) - have an expected maximum drop of around 45%. 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. Rebalancing 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 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 results using slightly 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, so 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 5% 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 all 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 it 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 – 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. Risk is the only way to achieve true financial freedom.

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