Avoidance of loss is the surest way to ensure a profitable outcome.

Be fearful when others are greedy

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.




Stocks do outperform bonds and cash over the years

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. 



Equities are inherently riskier than debt instruments

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.

Risk avoidance is the single most important element of an investment program

Another common belief is that risk avoidance is incompatible with investment success. This view holds that high return is attainable only by incurring high risk and that long-term investment success is attainable only by seeking out and bearing, rather than avoiding, risk.

Why do I believe, conversely, that risk avoidance is the single most important element of an investment program?

• If you had $1,000, would you be willing to wager it, double or nothing, on a fair coin toss?  Probably not.
• Would you risk your entire net worth on such a gamble?  Of course not.
• Would you risk the loss of, say, 30% of your net worth for an equivalent gain"  Not many people would because the loss of a substantial amount of money could impair their standard of living while a comparable gain might not improve it commensurately. 

Conclusion:

If you are one of the vast majority of investors who are risk averse, then loss avoidance must be the cornerstone of your investment philosophy.