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The Importance of Avoiding Large Losses

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The Best Way to Make Money is to Not Lose It

One of the key tenets of behav­ioral finance is loss aver­sion the­o­ry — the idea that investors feel the pain of loss­es much more acute­ly than they feel the plea­sure derived from gains. This is one of the few areas where the psy­cho­log­i­cal, irra­tional ten­den­cies of behav­ioral finance actu­al­ly square up well with sober, ratio­nal math­e­mat­ics. As we will illus­trate in this blog post, min­i­miz­ing loss­es is more impor­tant to the ulti­mate suc­cess of an invest­ment plan than max­i­miz­ing gains.

A Miracle in Reverse

In a pre­vi­ous blog post, Growth Cre­ates Growth, we explored the pow­er of com­pound­ing returns. If an invest­ment is allowed to grow at a con­stant rate, the appre­ci­a­tion of wealth accel­er­ates.

How­ev­er, the “mir­a­cle” in the mir­a­cle of com­pound­ing returns depends upon a con­stant rate of growth. Loss­es, or neg­a­tive returns, can throw an invest­ment plan off course and severe­ly impact the end­ing val­ue of the invest­ment. And just like com­pound­ing growth impacts wealth in an expo­nen­tial, non-lin­ear fash­ion, so do loss­es.

As before, the best way to demon­strate this point is via a sim­ple, the­o­ret­i­cal exam­ple. The fol­low­ing graph illus­trates the impact of loss­es on a the­o­ret­i­cal invest­ment of $100,000, in both dol­lar terms and stat­ed as per­cent­age returns.

When we start off, the rela­tion­ship between loss­es and per­cent­ages is sim­ple and straight­for­ward: a loss of 10% is $10,000, a loss of 20% equates to $20,000, and a loss of 50% rep­re­sents $50,000. Noth­ing sur­pris­ing there.

The Math of Losses | Avoiding Large Losses | Swan Blog

 

How­ev­er, once we start talk­ing about the returns nec­es­sary to get our deplet­ed account back to our start­ing val­ue of $100,000, the dol­lars and the returns start to diverge. Sim­ply put, the larg­er the loss­es, the larg­er the gains have to be to recov­er the loss­es. An invest­ment worth $90,000 needs to return 11.1% to get back to $100,000, not 10%. An invest­ment worth $80,000 needs a 25% return to break even, not 20%. And an invest­ment worth $50,000 needs to return 100% to get to $100,000.

The graph below illus­trates the returns need­ed (in green) to com­pen­sate for the loss­es dis­cussed pre­vi­ous­ly (in blue). While loss­es increased in a straight, lin­ear fash­ion, the gains need­ed to recov­er from those loss­es do not; they grow at an expo­nen­tial rate. In plain Eng­lish, the deep­er the hole, the more dif­fi­cult it is to work your way out of it.

Gains Needed to Offset Losses - Avoiding Large Losses | Swan Blog

Gains Needed to Offset Losses - table - Avoiding Large Losses | Swan Blog

Grant­ed, this is a sim­ple, the­o­ret­i­cal exam­ple used to prove a point: that loss­es are more impor­tant than gains, every­thing else being equal.

What impli­ca­tions does this have for real-world invest­ing?

Many investors are obsessed with the idea of “beating the market.”

Out­per­form­ing the S&P 500 is too often the only mea­sure many investors look at when deter­min­ing the suc­cess or fail­ure of an invest­ment strat­e­gy. The clam­or for beat­ing the mar­ket becomes espe­cial­ly pro­nounced dur­ing a long bull mar­ket after mem­o­ries of the last bear mar­ket start to fade. In such envi­ron­ments, investors myopi­cal­ly focus on the last one, three, and/or five years of mar­ket returns and are dis­ap­point­ed when any­thing — diver­si­fied port­fo­lios, dif­fer­ent asset class­es, con­trar­i­an strate­gies, etc. — fail to out­per­form “the mar­ket.”

How­ev­er, the job of out­per­form­ing the mar­ket becomes much eas­i­er if loss­es are min­i­mized in the first place.

The graph below is from Crest­mont Research and illus­trates this phe­nom­e­non.

Gains Needed to Beat the Market if Absorb Losses - Avoiding Large Losses | Swan Blog

The right­most por­tion of the diag­o­nal line states that if an investor expe­ri­ences all of the market’s loss­es, then the investor will also need to cap­ture all of the market’s gains in order to match the mar­ket.

That much should be obvi­ous. How­ev­er, the left-most por­tion of the diag­o­nal line shows that if the investor avoid­ed all of the market’s loss­es, then they would only need to cap­ture 26% of its gains in order to match the mar­ket returns over the long-term.

 Of course, it is unlike­ly that any­one invest­ed in the mar­ket would expe­ri­ence 0% of its loss­es. Real­is­ti­cal­ly, the focus should be on the mid­dle of the graph. In the mid­dle of this range, an invest­ment with a 40% down cap­ture needs a 55% up cap­ture to match the mar­ket. More­over, an up cap­ture in excess of 55% would see the invest­ment out­per­form the mar­ket over the full-time frame.

Win by Not Losing

This fun­da­men­tal rela­tion­ship is at the core of Swan’s Defined Risk Strat­e­gy (DRS). The DRS was designed to min­i­mize the impact of large loss­es. The DRS will lag in extend­ed bull mar­kets, but that is by design. As this post illus­trates, min­i­miz­ing loss­es is ulti­mate­ly more impor­tant than max­i­miz­ing gains. In oth­er words, the best way to make mon­ey is not to lose it in the first place.

Avoid­ing, or at least min­i­miz­ing, loss­es is the sec­ond of four key take-aways from Swan’s white paper “Math Mat­ters: Rethink­ing the Math Behind Invest­ment Returns.” As a recap, the four are:

  1. The impor­tance and pow­er of com­pound­ing
  2. The val­ue of avoid­ing large loss­es to returns
  3. The impor­tance of vari­ance drain
  4. The val­ue of a non-nor­mal dis­tri­b­u­tion of returns

The next blog post in this series will explore vari­ance drain.

Click to learn more about Swan’s Defined Risk invest­ment approach and for more details regard­ing his­tor­i­cal per­for­mance.

For more infor­ma­tion please con­tact Swan at 970–382-8901.

 

 

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsAbout the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.
Impor­tant Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non­qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains.  This analy­sis is not a guar­an­tee or indi­ca­tion of future per­for­mance. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970.382.8901 or vis­it swanglobalinvestments.com. 155-SGI-062816[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]

By | 2017-08-21T15:44:18+00:00 August 10th, 2016|Blog|Comments Off on The Importance of Avoiding Large Losses

About the Author:

As Director of Investment Solutions, Marc is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.