Playing not to Lose: How Successful Investors Win
One of the most unnerving events for a diehard football fan is to witness their beloved team jump out to an early lead. Players relax as the coaching staff change from their initial game plan (that got them off to a great start) to a much more conservative game plan that more often then not allows their opponents to get back into contention. This conservative method is often described as “playing not to lose,” and while it might be problematic in sports this very same approach sets the foundation for successful investors.
The typical investor is geared up to chasing the easy money and believes that in order to get big returns you must take big risks. Unfortunately this type of investment philosophy is backwards thinking; instead limiting portfolio losses is the most crucial aspect to successful investing as it will lead to big returns. Legendary investor Warren Buffett states, “The first rule of investing is don’t lose money; the second rule is don’t forget Rule No. 1.” In recent years, return performance has received the spotlight throughout the investment industry; however more attention should be placed on avoiding losses. The chart below illustrates the negative impact of losses on a portfolio.
As you can see the gain required to recover from a loss is exponential in nature; similarly a relatively small loss can eliminate a large gain. For example, any buy and hold investor from late 2007 through early 2009 (market peak to trough) lost approximately 57% of his/her portfolio, and in order to offset that loss they would need a gain of 133% (which could take several years in a secular bear market).
This concept of limiting losses is even more crucial for investors that depend on income from their investment portfolio (i.e. Retirement Accounts). Withdrawals from these portfolios impair gains while intensifying losses, making it even more important for consistent portfolio returns with minimal losses. Let’s assume now that the previously mentioned buy and hold investor withdraws 1.25% quarterly (5% annually) from the portfolio to pay for living expenses. What percentage gain does he/she need to recoup the investment losses in addition to the withdrawals? The investor would need over a 182% return on their portfolio to just break even.
This simple mathematical fact that the gains required to offset a loss are exponential in nature demonstrates the importance of limiting investment losses. Learning not to lose might seem boring but investors will be more successful if they master limiting portfolio losses rather then simply search for large gains.
As always, please feel free to leave any feedback in the comments sections below. I look forward to your comments and I will have a new investment article posted early next week.
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