How to win from losing investments
Losing money from time to time is great for long-term returns.
Disciples of Warren Buffett will be familiar with his first two investing rules: rule no.1 is to never lose money; rule no.2 is to never forget rule no.1.
This is useful advice because eliminating costly mistakes – like Michelangelo removing every piece 'that isn't David' – is the surest path to higher returns for most investors.
But an investor's goal shouldn't be to make zero mistakes. In fact, setting out to do so would be a bigger mistake, because mistakes are not only an unavoidable part of the investing process but a desirable part.
I'm not talking about paper losses that naturally occur from the market's fluctuations either. I'm talking about permanent capital loss.
I'll explain what I mean with an example. Let's say we are starting with a new portfolio today with the aim of not losing on any investment. Our aim would cause us to overlook 'uncertain' businesses in favour of those with greater certainty. In doing so, we would be severely capping the portfolio's return potential.
We may achieve our aim with a mistake-free track record but it would come with a hidden cost of many missed opportunities. The optimal loss ratio is much higher than 0%.
I'll admit that I've been guiltier of this than most. I used to fixate on finding investments with almost no downside risk (I even have ‘asymmetric one baggers' written on my bedroom mirror). Until I realised that I was overlooking stocks that did have greater downside risk, but had higher upside potential and a better overall expected return. The type of proposition that can be managed with smaller position sizes (a 10% investment in a stock with zero downside and 100% upside has the same impact as a 1% position in a stock that can go bust or ten-bag). A 'never lose' strategy could never venture into these areas.
Buffett's ‘never lose' comment works better at the portfolio level. Everyone wants their portfolios to never take a backward step, but that doesn't mean every investment within it needs to.
The concept of the overall system benefiting from the failure of its smaller components is put forward by Nassim Taleb in Antifragile. Using an example of the restaurant industry (which benefits from the constant failure of individual restaurants) he describes how “the antifragiity of the higher level may require the fragility, or sacrifice, of the lower one”. This seems true of portfolios too.
The most positive aspect of mistakes is the lessons they provide, although it's up to the individual to take advantage of their teachings. We should all strive to be like the Federal Aviation Administration, which makes aviation safer by conducting intense post-mortems of crashes. If you don't have an investment checklist, you should.
I've been lucky to lose small amounts in my early investing years that have helped me avoid losing much bigger sums more recently. And I hope today's mistakes will save me a lot in the future.
What we don't want to do is develop deep psychological scars after experiencing a loss that handicaps our future investing. Accepting that loss is a natural part of investing is a good place to start here.
So next time you have a loss, learn the lesson, dust yourself off, and get investing. Life goes on.
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