Rule No. 1: Never Lose Money
Rule No. 2: Never Forget Rule #1—Warren Buffet
If you have been around the investment industry much, you’ve probably heard that if you miss just a few of the best days it has a massive impact on your investment return. Back in January, Jason Zweig mentioned some updated research on this concept. Turns out that if you miss the 10 best days, only 10 days out of the last 109 years of trading, you wiped out 2/3 of the cumulative return of the Dow Jones.
The lesson has always been that since you don’t know the best 10 days, you have to stay fully invested so you don’t miss them. What stuck out in the Zweig article was the next line:
Conversely, had you sidestepped the market’s 10 worst days, you would have tripled the actual return of the Dow.
What?
I had never heard that side of the story! I wondered if it was just because I’ve always been a blind optimist, or if this other side is never talked about. Either way, the same conclusion has been made: since you never know when those bad days are coming, you should just stay fully invested. But I have been wondering if there isn’t another lesson here: losing money is far more painful [emotionally & financially] then making it.
Of course, there is no reliable way to completely sidestep the best or worst days, but there are ways to reduce your exposure to those “worst” days. You could lower your exposure to stocks. You could use some sort of insurance product. You could use a put option to protect your portfolio. I’m sure there are others. Traditionally, we have focused on the costs associated with a reduction of risk, but the last 12 months have helped many of us realize that the costs [emotional & financial] of unprotected equity exposure might far outweigh the benefits. It turns out that higher returns do not always lead to more money if it comes with greater risk.
This becomes even more obvious when you understand how hard it is to dig out from a major decline. Remember, if you are down 50% it takes a 100% return just to get even. There is a reason that never losing money is Mr. Buffet’s number one rule!
I want to be clear: I am not saying you should run out and buy insurance [for example]. I am saying that we have placed way too much emphasis on the return side of the equation and that if you are going to practice unprotected equity investing you need to better understand the risks!
{ 9 comments }
On the 10 best/worst days, the real take away ought to be that the significant activity can happen in tiny bursts. 10 days in 109 years of trading is only about four one-hundredths of one percent of those trading days.
It's kind of like watching soccer. There is 90 minutes of play, but if you turn away for 2 seconds (about 0.04% of 90 minutes), you could miss a goal.
Also, I couldn't agree more about the over emphasis on returns.
This is old news. What is more interesting is that if you miss both the 10 best and 10 worst of any total return series, it is usually statistically indistinguishable from not missing any days. Few are so good as to be able to sit out tops while the mania goes on, and buy in when the panic is deepest.
This is why buy and hold is not dead. People say it is dead during bear markets and volatile markets. In bull markets buy and hold is lauded. What average investors need to do is size their risky assets to a level they can live with, and then buy and hold, because they are not constitutionally adapted to market timing.
Or, consider what Eddy said today, quoting Tadas at Abnormal Returns:
http://www.crossingwallstreet.com/archives/2009...
“It turns out that higher returns do not always lead to more money if it comes with greater risk.”
Higher risk means just that: The opportunity for higher returns AND the opportunity for greater losses. That's why risk management is so important.
The positive side of the equation is emphasized because it is Wall Street's job to convince people to buy and own stocks forever.
there are ways to reduce your exposure to those “worst” days. You could lower your exposure to stocks. You could use some sort of insurance product. You could use a put option to protect your portfolio. I’m sure there are others.
You could take a look at the price you are paying for the stocks you buy before setting your allocation.
There has never been a time in the history of the U.S. market when stocks purchased at reasonable prices provided a poor long-term returns. There has never been a time in the history of the U.S. market when stocks purchased at insanely high prices provided a good long-term return.
You could look it up.
We make discussions of risk more complicated than they need to be. Risk is investing passively. Take prices into account (as we do when buying everything else we buy except for stocks) and 80 percent of the risk of stock investing goes “poof!” It's not stock investing that is risky. It is Passive Investing that is risky.
Rob
>Losing money is far more painful [emotionally & financially] then making it.
Yes, that is human psychology but it isn't really logical… Isn't reacting to that perceived pain a big factor that creates the behavior gap? Why not learn how to deal with that pain and stick to your plan instead of trying to insure against?
>the last 12 months have helped many of us realize that the costs [emotional & financial] of >unprotected equity exposure might far outweigh the benefits. It turns out that higher returns do not >always lead to more money if it comes with greater risk.
I've been very happy with the opportunity from last 12 months… in fact I WISH the market had taken LONGER to recover so that I could have bought MORE cheap stocks. I didn’t like seeing my account balances drop, but I don’t NEED to sell any shares for another 25 years so I kept Warren’s rule in mind and didn’t sell. I didn't turn the paper losses into real losses. I also followed Warren's other advice: “..be fearful when others are greedy and greedy when others are fearful” and increased my IRA contributions. Both turned out to be very good advice in the short term, likely very great advice in the long term.
-Rick Francis
Mark- that is correct, but what I am referring to here is that even after
the fact, just because one has a higher average annual return does not mean
that you end up with more money than another investment with a lower annual
rate of return.
This is “old news” for some of us in the industry, but most [almost all]
people find shocking is that you can have an investment with a lower return
and up with more dollars at the end. In other words when choosing two
investments even with perfect foreknowledge it is not always the one with
the higher average annual rate of return that ends up with more dollars…
This is called “risk drag” or “volatility drag” and is something that
receives far too little attention. We have a post coming about it.
I know you know this, but most people don't.
>Losing money is far more painful [emotionally & financially] then making it.
Yes, that is human psychology but it isn't really logical… Isn't reacting to that perceived pain a big factor that creates the behavior gap? Why not learn how to deal with that pain and stick to your plan instead of trying to insure against?
>the last 12 months have helped many of us realize that the costs [emotional & financial] of >unprotected equity exposure might far outweigh the benefits. It turns out that higher returns do not >always lead to more money if it comes with greater risk.
I've been very happy with the opportunity from last 12 months… in fact I WISH the market had taken LONGER to recover so that I could have bought MORE cheap stocks. I didn’t like seeing my account balances drop, but I don’t NEED to sell any shares for another 25 years so I kept Warren’s rule in mind and didn’t sell. I didn't turn the paper losses into real losses. I also followed Warren's other advice: “..be fearful when others are greedy and greedy when others are fearful” and increased my IRA contributions. Both turned out to be very good advice in the short term, likely very great advice in the long term.
-Rick Francis
Mark- that is correct, but what I am referring to here is that even after
the fact, just because one has a higher average annual return does not mean
that you end up with more money than another investment with a lower annual
rate of return.
This is “old news” for some of us in the industry, but most [almost all]
people find shocking is that you can have an investment with a lower return
and up with more dollars at the end. In other words when choosing two
investments even with perfect foreknowledge it is not always the one with
the higher average annual rate of return that ends up with more dollars…
This is called “risk drag” or “volatility drag” and is something that
receives far too little attention. We have a post coming about it.
I know you know this, but most people don't.
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