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!
