David Fabian: I recently had a very important conversation with a new client of my firm that was describing to me how their previous investment adviser destroyed their portfolio. The adviser was so convinced of a certain outcome in the market that he overrode his own risk management philosophy to the peril of his clients. I won’t go into the specifics of how it happened, but the lesson that stood out more than any other is that you should never let your conviction of a certain direction or investment theme destroy your portfolio.
I have seen this same story repeated over and over again by both individual investors and professional money managers. They get so convinced that “the top is in” or the “ride is over” that they end up making drastic changes to their directional bias. One example of this includes selling all of your stocks and purchasing the AdvisorShares Ranger Equity Bear ETF (NYSEARCA:HDGE) because you believe the market can’t possibly go any higher. I know one portfolio manager that has held onto this fund for nearly a year with no plan in place to manage the losses. You can draw your own conclusions as to how that has worked out.
The problem is not that you bought an investment that didn’t make you money. Everyone who has been investing for more than a year probably has a few trades they would like to take back or opportunities that they have missed. The problem is that you get so convinced of a certain outcome that you can’t see both sides of the trade and you set aside the rules of risk management.
Don’t ever forget that an investment can always go higher or lower despite all evidence to the contrary. That is because investing is not logical, it is psychological. The stock market can climb a wall of worry when the news is terrible or fall out of bed when everything seems great.
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.
Not only that, the psychological damage that large losses do to your confidence and quality of life is devastating. You don’t want to lie in bed awake at night hoping for a 50% gain in the iShares Silver Trust (NYSEARCA:SLV) just to get back to break even because you bought it at the top. I have said it before and I will say it again – hope is not an investment strategy.
Wouldn’t a better solution be to use a sell discipline and cut your losses when they are small rather than wait for them to get out of control?
That way you can regroup and prepare for another investment opportunity rather than praying for a recovery that may take months or years to come. Now the other side of that coin is that you may get stopped out of a holding and it immediately blasts off to new highs and leaves you in the dust. That is certainly a risk that you take when using stop losses. However, I believe that the risk of a big loss is far worse than the risk of lost opportunity.
Here are some of my investment rules that I follow for myself and my clients:
1. Always have a stop loss or sell discipline in place to manage the risk of a big loss. You are not going to pick winners every time, so make sure that you cut your losses early rather than waiting until it is too late.
2. Don’t get over allocated to one stock or sector. Many investors make the mistake of having too much of their money concentrated in a big winner like Apple Inc. (AAPL), only to watch it quickly deteriorate without a plan for banking their gains. I love my iPhone, but I am not in love with any of my investments.
3. Always have a watch list ready for new ideas. If you get stopped out of a position and go to cash, you should have a prepared list of stocks or funds that you are considering for new money. This list should constantly be evolving based on changes in the market.
Successful investing starts with the mindset of avoiding big losses and having clear investment rules to follow when all else fails. If you follow the rules, you won’t get in trouble.
This article is brought to you courtesy of David Fabian from Fabian Capital Management.