One of the greatest challenges to saving and investing is the negative power of losses. That’s why long-term investing success doesn’t hinge on winning big or hitching yourself to every gain. Real long-term investing success is about learning how not to lose. Inevitably, if an investor remains in the markets long enough, they will be exposed to bear markets and will face a long road to recovery—a long road many people simply can’t afford. But, here’s the good news: You can have market success without overexposing your portfolio to catastrophic losses in a bear market. Let’s take a look at some of the key factors that drive the power of losses and what investors can do to overcome them.
The Psychological Loss
Let’s face it. As human beings we hate to lose. Think of professional athletes, or better yet, ask one about their exploits on the gridiron or the baseball diamond. Invariably, mixed in among their many successes they’ll return to their losses. A dropped pass. A strikeout in the ninth inning. There’s something hardwired within us, an idea termed prospect theory, that makes losses deliver a more emotional impact to us than an equivalent gain.
The Emotional Factor of Financial Loss
Emotions play a huge role in investment decisions. And that’s not a good thing. We are, for better or worse, emotional beings, but emotions should not play a role in our investments. Think about it for a moment. If your emotions are high, if you’re at an emotional moment in your life with various stresses pulling at you, you’re not going to make the best decisions. There’s just too much going on in your brain, too many distractions, too much stress. (For related reading, see: How to Avoid Emotional Investing.)
The 24/7 Financial Market Information Cycle
We hear about the 24/7 news cycle, but it’s the same these days with financial markets. Investors have notifications and alerts set to their smartphone and other electronic devices. When the markets have an off day, investors are constantly getting pinged about their stocks. They’re watching in real time, through apps and other alerts, as their investments are being picked apart. This exacerbates their emotional state. We hear about frothy markets, but this constant information cycle causes a frothy brain. Investors can’t get away from the information. Even if they walk away from their computer and turn off their phone, they might see more disturbing news on the TV at the gym when they’re walking on the treadmill.
The Real Loss of Losses
As if the psychological and emotional aspects of losses weren’t bad enough, there’s an actual mathematical aspect to losses in the markets. Unfortunately, many investors think gains and losses are symmetrical, but they are far from it. Someone assumes that a 10% gain is equivalent to a 10% loss. Actually, if you have a minus 10, you will need a plus 11 to get back to even. In this case, the loss is more powerful than the gain. What about the case when an investor is in that period of life when he or she is taking withdrawals out of their portfolio? At that point, they’re exaggerating everything to the downside and nothing to the upside. Everything is going in the wrong direction. Even if you’ve got a gain of 10% for the year and you’re taking 5% out, you’ve only gained 5%. Now, what if the next year your portfolio loses 10% and you still take 5% out. Exactly—you now have a loss of 15% that year, and the losses really are more powerful than the gains. (For related reading, see: How Do You Calculate the Percentage Gain or Loss on an Investment?)
A Strong Defense Against Losses
To offset the power of losses, it’s key that you build a strong defense. By being defensive in your investment strategies, you may not always get to your goal, you may not wind up a billionaire, but you will have a hedge against catastrophic losses. To remove the emotion and a seat-of-your-pants philosophy, it’s important to build that defense through mechanical models. One winning example is the S&P 500 strategy. Most people forget that the S&P 500 has a set of rules it follows. It’s a fairly simple rule, but it follows it every day—buy the 500 largest market cap companies and it’s weighted based on their size every single day. Some days are good, some days aren’t, but it sticks to that plan, and in doing so, outperforms 80% of the professional managers who are actively trading.
The other aspect of a strong defense is to put in place a stop-loss plan. Bear markets are inevitable. You can try to time them, but good luck with that. The better plan is to implement a mechanical model that has a designated stop-loss of say 10%. If a sector you’re invested in goes below that 10% threshold, then you sell, saving you from the catastrophic losses of a prolonged bear market. In following that strategy, you won’t hit every time. In fact, you might miss 50% of the time, but you will have taken the emotional and psychological pain out of investing and you will have effectively weakened the power of losses.
(For more from this author, see: Taking the Emotion out of Investing.)