- Breaking Even After a Loss
- Volatility as Risk
- Sequence of Risk
- Accumulation (Building Wealth)
- Arithmetic Average
- Geometric Average
- Expected Value
- Monte Carlo
- Surprising Losses
- Fat Tails
- Convinced to Never Lose Money?
- Measuring Risk
- At Home
- In The Bank
- Asset Allocation
- Prior Crashes
- All Dropped Together
- Via Negativa
- Medical Risk Analogy
- Safe Havens
Never lose money. If you can do that, feel free to stop reading now. The more experience I gain as an investor, the more I realize the importance of not losing money. It seems obvious. To build wealth, you shouldn’t lose a lot along the way. In my personal investing, I didn’t emphasize this much. I now have a deeper understanding and value the rule more.
“Rule #1. Never lose money.
Rule #2. Never forget Rule #1.”
– Warren Buffett
Breaking Even After a Loss
The richest investors I know obsess over not losing money.
One reason is the simple arithmetic of recovering from a loss.
If you lose 25% and then gain 25% are you back to where you started? No. Breaking even requires a 33% gain.
|Loss||Gain Needed to Recover|
You can’t compound your wealth if you take large cuts.
The market isn’t normally (Gaussian) distributed. Stock price distributions don’t always look like a perfect bell curve. The tail of the curve may be thick rather than thin and tapering. The right side may not look exactly like the left. We can’t just assume that math based on a perfect bell curve will work with stock prices. We can’t calculate the probability of negative tail risk events.
Furthermore, the past isn’t predictive of the future. Even if we mathematically mapped out the shape of the distribution, we may never see that again.
Volatility as Risk
The standard measure of financial risk is volatility.
Yet volatility is a flawed and incomplete measure. Price stability does lower risk so volatility as a risk measure isn’t way off base. It is incomplete in representing the average investor’s concern.
One issue is that when prices go up and down it might happen to be down when you need the money. If you sell after a price decline, you get less money. Worse, that is a permanent loss to your portfolio.
Fluctuating prices during our working years (accumulating) have less impact than during retirement.
Sequence of Risk
Sequence of Return Risk (SORR) can devastate a retirement nest egg. A large market decline at your retirement’s start can wipe you out. When share prices are low you need to sell huge tranches of stock to meet your cash needs. Even if stocks rebound to prior levels, you will own fewer shares and will be worse off.
During retirement, losses of -20%, -35%, -10%, +40% is much worse than +40%, -10%, -20%, -35%. The order of gains and losses is critical.
Accumulation (Building Wealth)
During accumulation the order doesn’t matter. Do you agree?
If you experience a 20% loss followed by a 20% gain versus a 20% gain followed by a 20% loss, would you end up with the same amount?
Yes, you would. But only if you don’t have to sell after that first loss.
This math explains why we can better tolerate volatility during our working years. That implies a higher allocation to stocks.
Even so this “volatility drag” or “convexity risk” will still damage your portfolio. Convexity cost is another factor that erodes wealth.
For example, if you started with $100 before the 20% gains and declines described above, how much with you end up with? Since the gains cancel out the losses (both 20%) and you don’t sell shouldn’t you end up with $100?
The arithmetic average of -20% and +20% is zero. Your mutual fund report would state there was no loss or gain. The normal average we calculate is based on the SUM of the terms. Add them up and divide by the number.
Arithmetic Average = (R1 + R2 + R3 …)/ N
(-20% + 20%)/2 = 0/2 = 0%
Easy, right? That’s the number we read and think about. The problem is that it’s fiction with no relation to our wealth.
The compound annual growth rate (CAGR) or geometric average is what matters. That tells the true story. We need to MULTIPLY the terms, not add them.
Geometric Average = [(1+R1)(1+R2)(1+R3) … ]1/N – 1
(1+20%)(1-20%)1/2 -1 = SQRT [(1.2)(0.8)] -1 = -2%
The truth is your account would have only $96 after that volatility. There was a $4 loss. The order of the changes doesn’t matter.
$100 – 20% = $80 + 20% = $96
$100 + 20% = $120 – 20% = $96
This was a real head-scratcher for me to work through. Andrew Lo explained this idea from Myron Scholes in his book, In Pursuit of the Perfect Portfolio.
Business school decision making classes focus on expected utility. That’s calculated by the product of likelihood and impact. Frequency times outcome. This improved thinking model takes into account probability and results.
Let’s say I have only $100K to invest. I’m offered a private equity investment. There’s a 10% chance it will pay off and triple my money. A 25% chance of going broke and a 65% chance of making $5K profit. What’s this deal worth?
The calculation would look like this:
(10%x300) + (25%x0) + (65%x105) = 98.25
I would pass since I would be paying $100k for a deal worth $98.25. I would not be rewarded for taking risk.
Unlucky SORR can wipe you out more than expected utility would calculate. We live only one life not thousands of imaginary Monte Carlo simulated lives.
For example, is betting heads you win, tails you lose a good bet? You may respond that it depends on the odds and outcomes. What if the outcomes are equal and the odds are positive on average. Is it a good bet?
No, it isn’t. Despite the positive expected value calculations.
Here’s an example. You start with $100.
We bet on coin flips. The coin is legit, and the odds are exactly 50-50 for heads or tails. If a tail comes up, you lose 40%. If a head comes up, you gain 50%. Is this a good deal? Would you take the bet?
Expected gain = (0.5 x 50 + 0.5 x -40) = 5.
Thats $5 or 5% of wealth. Not bad, right?
My MBA training tells me to grab as many of those deals as possible. Better still, buy options with leverage to boost the 5% return. That logic helps people and institutions go bust!
Despite the calculated positive expected gain, this isn’t guaranteed to be a good deal. Simulations by Jason Collins of 10K people taking that bet resulted in a median after 100 flips of 51 cents (99% loss). Most wealth invested that way declines and it should. Expected value is flawed.
The math and concept of ergodicity and fat tails can be difficult. But we can all understand some basics. With nonlinear systems thinking in averages is wrong. For most people it ends in disaster.
As we saw, you can lose money on a positive expected value bet.
High-earning physicians shouldn’t need to take on excess risk to boost returns. The key is just don’t blow up and lose.
Thinking in “parallel worlds” is a mistake. You live in only one world. The average may be okay, but you still go broke.
Convinced to Never Lose Money?
OK, so I convinced you the importance of not losing money. That’s still easier said than done. Now that we know why we don’t want to lose, how do we carry this out?
Risk and reward go together. Avoiding all risk will wipe out your prospect of large financial reward.
The most common measure of financial risk is volatility, but it has its defects. A better measure would be maximal drawdown (peak to trough). The losses are real and scary. In my lifetime there have been ten drawdowns over 15% in global equities averaging -27% (per Citi Research, Factset).
Global Financial Data of asset class real returns aren’t more comforting. From 1913-2013 maximum drawdowns were -52.38, -59.06%, & -78.94 for a blended fund (60/40), bonds, and stocks respectively.
Not having the money you need when you want it is the most serious risk (inadequate terminal wealth).
So how do we avoid losing money?
Under a mattress? I have known a few rugged individualists who have stacked $100 bills under a mattress. They are exposed to several risks including theft and fire.
In The Bank
Savings account? FDIC insurance prevents losses from bank failures and is backed by the Federal government. After the Great Financial Crisis (GFC) of 2008 Federal regulators raised limits from $100K to $250k.
Such safety comes with a price of minimal reward. There is no “miracle of compound interest” when the banks pay 0.1%
And then there is inflation risk. The Federal Reserve has targeted 2% inflation as a goal. That means our government intends to reduce the purchasing power of your money over time.
An $800 suit will cost more later due to the purchasing power destruction of inflation. Your money in the “safe” bank savings will decay every year. You are guaranteed to lose money over time.
Large cash piles create other risks. Spending is easier. “Emergencies” come up that otherwise would have gone away. Family members see the money as spendable. You feel cash-rich and spend more. You risk investing without doing due diligence. That makes you susceptible to fraudulent investment schemes.
CDs come with low yields and penalties for early withdrawal. Money market accounts pay more than saving/checking accounts but aren’t guaranteed or FDIC-insured.
Bonds decline in value with rising interest rates.
Interest rate changes are impossible to predict. Yet when rates are near-zero there’s no place to go but up.
The “safe” bonds in your portfolio will experience losses when interest rates rise.
If we can’t keep all our money safe, what are we to do?
This circles back to asset allocation. How much of your portfolio should be placed at risk in hopes of future rewards vs safe from losses?
All the factors that go into this decision is for another post. As for now, consider all your money as sitting in one of two buckets. At risk or not at risk.
Diversification is the saving grace in personal investing. Owning many, uncorrelated asset classes boost returns. Even better is that it also reduces portfolio volatility. More return without much risk. This may be the only “free lunch” in investing.
My boring large value stocks, real estate, and bonds helped me weather the market downturn of 2000. That taught me the value of diversification. I increased my number of asset classes by slicing and dicing my portfolio into a dozen pieces from REITs to emerging markets. Yet, in 2007-2008, everything went down together – and fast. Only my bonds went up.
I learn from bad experiences. After recovering my 2008 losses I made more changes. I decreased my stock allocation, simplified my portfolio, and increased my bond holdings.
All Dropped Together
I was more diversified when 2022 came along. Maybe you could avoid losses by investing widely in diversified assets. And yet, where was the benefit? Here are some examples of asset class results for 2022 year-to-date.
We need to win by not losing. Avoid blowing up. Via Negativa.
I respect Nassim Nicholas Taleb (NNT) due to his vast experience and insights, so I reached out to him for advice. After describing to NNT my situation with life and investing he gave me excellent advice. My “F-U Money” (Freedom Unlimited) allowed me financial freedom. It provided an array of employment options. It allowed me to work in academia, work for a non-profit, or work part-time.
“I would stop trading now because further profits won’t change your life, but more losses would make you exit that state!”
– Nassim Nicholas Taleb
I followed up asking about options strategies rather than avoiding equity risks. His response was helpful.
“Options are not easy to trade for individual investors because of transaction costs. There are other ways but only with instruments offering “optionality” – in fact quasi-options, but these are impossible to trade for individual investors.” -NNT
How to get rich?
“People become rich by not going bust (particularly when others do).”
– Nassim Nicholas Taleb
Medical Risk Analogy
These concepts shouldn’t be new to us risk-averse physicians. I’m reminded of an editorial by Dr. Curt Tribble who shared a teaching moment from an ER experience. His resident treated a patient with abdominal pain and microscopic hematuria. Even though the resident palpated a small triple-A, he played the odds and treated the patient for a kidney stone.
Later the patient returned with a ruptured abdominal aneurysm. I’m paraphrasing his explanation to his resident. “You’re thinking about kidney stones was correct, but you were wrong by what you were NOT thinking.“
“What’s the worst or most ominous thing that the patient might have? One must put more weight on the consequence of a possible diagnosis than on the likelihood of that diagnosis. No one dies of a kidney stone, but people with leaking aortic aneurysms often do.”
So where does this leave us when seeking for safe returns?
Some options to consider. You will never lose money with these.
- Invest in yourself. Personal mastery. Professional development.
- Advanced technical skills or education.
- Job skills diversification and habit stacking.
- SPIA, DIA, MYGA.
- Pay off debt.
- Short-term, high-quality bonds.
- Continued earnings.
- Treasury bills and notes.
- Consider a barbell portfolio. For example, 90% risk-free short-term treasuries and 10% in options or high-risk equity.
A barbell approach may not capture the maximum returns from all asset classes. But you will not go bust. Remember Rule #1 – Never Lose Money!
What about you? Did you lose money in 2022? How will that experience improve you as an investor? Please share your ideas on how to remove risk from a portfolio.