Yesterday I talked about how losses are more costly to a fund than gains are beneficial by showing the rate of return required to recover from various levels of trading losses. As that chart showed, it can take quite a while to recover from investing mistakes.
This concept of prioritizing avoiding losses above chasing gains is so important, yet so wildly overlooked by the financial industry. How is it that it’s so rarely discussed? Isn’t the pattern clear?
The average investor did well in the 90’s and then got crushed by the dot.com bust. The mid 2000’s were good times again and the average investor recovered, only to get crushed again in the financial crisis. Central banks came in and saved the day, things recovered and the average investor today is again feeling like they’ve recovered. And for many they’re ramping up the risk taking. No forward market predictions of course but this doesn’t strike me as a time to be taking on risk. Regardless, why is loss avoidance so important?
Let me illustrate this another way.
- Imagine there are 3 hypothetical investors
- All 3 of them start with 10,000$
- All 3 of them make a mean average of 10% a year
- Each has a different level of risk appetite so the distribution of returns vary
Investor A targets maximum consistency.
Investor B takes some risks and is rewarded with some good years, but also occasionally suffers losing years.
Investor C takes on a lot of risk and it pays off big time in good years, but is very costly in down years.
So all three investors got the same mean average annual rate of return of 10% but the more inconsistent those returns were achieved the worse their result. Clearly with geometric compounding of investment returns, consistency wins the race.
Now it’s true that investor B and C from the above examples will have bragging rights during those good years, but the consistent trader always gets the last laugh.
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