3. Big Losses Are Difficult To Recover From
In investing there are four certain outcomes: (1) a big gain, (2) a small gain, (3) a small loss, and (4) a big loss. Three of these outcomes are acceptable. Everyone can agree that a big or small gain is going to move the needle forward on your portfolio and even a small loss won’t derail you from reaching your goals. However, the big loss is the one cardinal sin that will haunt your dreams and hinder your performance.
The worst part about a big loss is how much harder it is to recover from. Remember that based on the rules of compounding, a 25% loss requires a 33% gain to get back to break even. A 50% loss requires a 100% gain to get back to break even. If you hang on to an investment with a loss of more than 25% and it continues to underperform, that money is just dead. It is not contributing to the long-term success of your portfolio and acts like a boat anchor attached to your money.
If 2008 taught us anything, it’s that there is no such thing as a safe stock and that big losses are difficult to recover from. That is why I always employ a stop loss or sell discipline on my invested positions to guard against the potential for a protracted decline. It’s not a perfect system, but it allows me to sleep well at night knowing that I have a limited amount of downside exposure.
The Bottom Line
Bulls often times have it easier than bears because despite every correction, recession, or depression the stock market has been resilient enough to march its way higher. Not every investment survives these cycles, but the system as a whole has been one that creates wealth for the majority of its participants.
I don’t align myself with either the bull or bear camp exclusively. Instead, I focus on building balanced strategies that take into account both sides of the trade and consider both the upside potential and downside risks. That way I am prepared for either outcome and can shape the holdings in my portfolio to align with the current market environment.
The drawback to this philosophy is that I lose out on some upside in raging bull markets, but by the same token I do not undertake the same perils during bear markets either. I try to keep some cash on hand to take advantage of strategic opportunities when they present themselves as well. This allows me the flexibility to add to holdings that I feel are represent a unique value or reduce exposure to investments that hit my upside targets.
This article is brought to you courtesy of David Fabian from FMD Capital Management.