Avoiding Investment Losses

Avoiding Investment Losses: What Really Drives Investors, and How To Use the “Golden Rule”

By Dr. Steve Sjuggerud, Investment U Advisory Panelist
Tuesday, December 10, 2002: Issue #194

“The overwhelming majority of mutual-fund investors are in the red this year,” says today’s Wall Street Journal. How you handle being in the red this year can mean the difference between retiring when you want and never retiring

In today’s E-letter, we’ll tackle the critical issue of avoiding investment losses particularly mitigating large thrashings that can destroy your portfolio. We’ll explore just how dangerous it can be for you to get this one wrong. And we’ll look at how – in this case – doing what “feels natural” might actually be the quickest way to the poorhouse

One thing I’ve found over the years is that many investors (including professionals) forget the importance of handling losses before they spiral out of control. I think it’s because investors often don’t spend enough time critically thinking about how they handle risk. They spend their time looking at company financials and stock charts. But they don’t spend their time contemplating how to correctly manage winners and losers.

The Factors that Really Drive Investors

People are extremely inconsistent – irrational – in the way they handle risk. Everyone thinks they act rationally based on all the information available looking for the lowest risk and highest return. But studies show this is not the case.

It turns out that people are not driven by risk aversion, as they believe. They are actually driven by loss aversion. Let me explain the difference

For example, I offer you the following two choices:

An 80% chance of winning $4,000 versus a 20% chance of earning nothing, or
A 100% chance of receiving $3,000.

Which would you choose? Even though the first choice is mathematically the better bet (with a mathematical “expectation” of $3,200), 80% of people choose the guaranteed money. That means, they aren’t willing to risk a small profit for a potentially bigger one.

Now let’s look at it from a loss perspective, with the following choices:

An 80% chance of losing $4,000 versus a 20% chance of breaking even, or
A 100% chance of losing $3,000.

Amazingly, 92% of people choose the first option. They take the gamble. That means, people will do anything to avoid an investment loss. When the choice involves losses, we are risk-seekers, not risk averse.

So hopefully you can see that nearly all of us are not consistent, symmetric, or rational in how we consider risk. And this can really hurt you in your investments

Avoiding Large Investment Losses Remember the Golden Rule

The Golden Rule of investing is to “cut your losses short and let your winners ride.” Nearly every successful investor on the planet abides by this rule – however, there are very few successful investors who regularly beat the markets. For the rest of us (about 99% of investors) following the Golden Rule seems too hard. As Peter Bernstein explains in Against the Gods: The Remarkable Story of Risk, “It is not so much that people hate uncertainty – but rather, they hate losing A loss taken is an acknowledgement of error.” That nails it on the head.

It’s not just in the stock market. It’s in all of life. Consider this astounding example of irrationality and risk, from Peter Bernstein

“Imagine that a rare disease is breaking out and is expected to kill 600 people. Two different programs are available to deal with the threat. If Program A is adopted, 200 people will be saved. If Program B is adopted there is a 33% probability that everyone will be saved and a 67% probability that no one will be saved.
“Which program would you choose? If most of us are risk-averse, rational people will prefer Plan A’s certainty of saving 200 lives over Plan B’s gamble, which has the same mathematical expectancy but involves taking the risk of a 67% chance that everyone will die. [When given the choice], 72% of people chose the risk-averse response represented by Program A.”
“Now consider the identical problem posed differently. If Program C is adopted, 400 of the 600 people will die, while Program D entails a 33% probability that no one will die and a 67% probability that 600 people will die. Note that the first of the two choices is now expressed as 400 deaths rather than 200 survivors, while the second program offers a 33% chance that no one will die. 78% of people quizzed were risk seekers and opted for the gamble: they could not tolerate the prospect of the sure loss of 400 lives.”

The explanation the researchers give for this is that people are not risk averse: they are perfectly willing to choose a gamble when they consider it appropriate. However, they are loss averse

Amazingly “Respondents confronted with their conflicting answers are typically puzzled. Even after re-reading the problems, they still wish to be risk averse in the “lives saved” version; they will be risk seeking in the “lives lost” version.“

Why Avoiding Catastrophic Investment Losses Is Key to Your Strategy

We, as investors, have to understand that we are not as rational as we think we are. What we are is loss averse. We want to be in a position whereby we are avoiding investment losses. However, if we are to succeed in investing, we must learn to take a loss, and take it early. And that is because a small loss can’t be allowed to become a catastrophic loss.

I talked about this a little last week in Investment U E-Letter #195 when I wrote about the impact of drawdowns. To give you an example, if a stock you hold falls by 25%, (say from $20 to $15), that means you only need to earn 33% to get back to where you started. However, if a stock you own falls by 90% (say from $20 to $2), that means it needs to rise by 900% to get you back to break even. Those are not good odds.

Smart investors recognize the need to go against what probably feels natural. And that means learning to cut losses early, and learning to let winners ride. Put simply, the way you make money is to combine a few small losses with big winners.

In order to win the war, you’ve got to learn to concede some battles. You’ve got to admit you’re wrong sometimes. That means recognizing the potential portfolio-crushing human instinct to avoid investment losses. And it means cutting your losses early before they can become catastrophic losses. Start now.

Good Investing,

Steve

Today’s IU Crib Sheet

The stories about how we’re irrational about risk all come from Against the Gods: The Remarkable Story of Risk by Peter Bernstein. This book, in a way a math history book, is not for everyone. But Bernstein is such a great writer he can make any topic interesting. You may want to check it out, visit Amazon.com.

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