Sunday, 12 February 2012

Avoiding loss should be the primary goal of every investor

Warren Buffett likes to say that the first rule of investing is "Don't lose money," and the second rule is, "Never forget the first rule." I too believe that avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather "don't lose money" means that over several years an investment portfolio should not be exposed to appreciable loss of principal.

While no one wishes to incur losses, you couldn't prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken. It can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker is on the phone offering shares in the latest "hot" initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.

A loss-avoidance strategy is at odds with recent conventional market wisdom. Today many people believe that risk comes, not from owning stocks, but from not owning them. Stocks as a group, this line of thinking goes, will outperform bonds or cash equivalents over time, just as they have in the past. Indexing is one manifestation of this view. The tendency of most institutional investors to be fully invested at all times is another.

There is an element of truth to this notion; stocks do figure to outperform bonds and cash over the years. Being junior in a company's capital structure and lacking contractual cash flows and maturity dates, equities are inherently riskier than debt instruments. In a corporate liquidation, for example, the equity only receives the residual after all liabilities are satisfied.  To persuade investors to venture into equities rather than safer debt instruments, they must be enticed by the prospect of higher returns. However, the actual risk of a particular investment cannot be determined from historical data. It depends on the price paid. If enough investors believe the argument that equities will offer the best long-term returns, they may pour money into stocks, bidding prices up to levels at which they no longer offer the superior returns. The risk of loss stemming from equity's place in the capital structure is exacerbated by paying a higher price.

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