The Power of Avoiding Losses

Losses occur for three primary reasons:

1. You took bigger risks and exposed yourself to a higher probability of loss.

2. You invested in an instrument that failed to keep pace with inflation and interest rates (e.g. CDs).

3. You didn't hold the instrument long enough to let its true intrinsic value be realized.

There aren't many ways an investor can avoid periodic losses. The best way is to invest all of your assets in bonds and hold them to maturity. You would, of course, experience an erosion in the value of the bond due to inflation. If interest rates rise during your holding period, the intrinsic value of the bond would fall and the yearly coupon wouldn't compensate you for inflationary pressures.

To reduce the chance of losses, you must minimise mistakes. The fewer errors made over your investing career, the better your long-term returns.

We've seen the advantage of adding extra points of gain to your yearly returns. Earnings an extra 2% points a year on your portfolio compounds into tremendous amounts. Beating the market's presumed 11% yearly return by 2% points would translate into hundreds of thousands of dollars of extra profits over time.

The same holds true if you can avoid a loss. When you lose money, even if for just a year, you greatly erode the terminal value of your portfolio.

• You consume precious resources that must be replaced.
• In addition, you waste precious time trying to make up lost ground.
• Losses also reduce the positive effects of compounding.

The effects of avoiding losses can be studied by considering 3 portfolios, A, B, and C, each of which normally gains 10% a year for 30 years. Portfolio B, obtains zero gains (0%) in years 10, 20, and 30. Portfolio C suffers a 10% loss in years 10, 20 and 30.

• A $10,000 investment in portfolio A would return $174,490 by the 30th year.
• Portfolio B would return considerably less - $131,100 - because of three break-even years. The portfolio never actually lost money, but will forever lag far behind porfolio A by virtue of having three mediocre years. Historically speaking, portfolio B's returns aren't all that bad, for the investor managed to avoid losses every year.
• Portfolio C, by contrast, loses 10% in years 10, 20, and 30. It's return of $95,572 was considerably lower. The effects of those three not-so-unreasonable years is to lop nearly $79,000 off the final value of the portfolio. That's what compounding can do. The actual loss in the 10th year was only $2,357. The loss in the 20th year was just $5,004; the final year loss was $10,619. But the power of compounding turned $17,980 in total yearly losses into $79,000 of lost opportunities.

Buffett once summarized the essence of successful investing in a simple quip:

Rule number 1: Don't lose money

Rule number 2: Don't forget rule number 1