Warren Buffett’s two main rules of investing are:
- Never lose money.
- Never forget Rule 1.
For example, let’s say you have two portfolio options with these returns over the next four years:
Investment A: 40%, 50%, -60%, 65%
Investment B: 20%, 15%, 17%, 20%
Which option would you prefer?
Recently, when I posed this question, Investment A was preferred since it appeared more exciting. But, if you take the average, Investment A will have a 23.75% average and Investment B, 18%.
While simple averaging does not work in the markets, the concept of compounding does. Let’s do that with the assumption that we invest Rs 100 in both.
| Investment A | Investment B | |
|---|---|---|
| After Year 1 | 140 | 120 |
| After Year 2 | 210 | 138 |
| After Year 3 | 84 | 161.46 |
| After Year 4 | 138.6 | 193.75 |
As we see, Investment B returns far more than Investment A after four years. The negative return in Year 3 destroys the overall long-term returns in Investment A.
These large drops in asset prices are something investors need to be aware of as they truly affect long-term returns and goals of the individual. Avoiding the big money mistakes are paramount for successful investing.
Let’s look at another way to understand negative returns and their impact on our investments by assuming a stock price of Rs 100.
| Stock price falls by | Need to gain |
|---|---|
| -25% | +33% |
| -50% | +100% |
| -75% | +300% |
| -90% | +900% |
As we see, if an investment falls by 25% (100 to 75), to get back to the original purchase price, the investment will have to go by 33% (75 to 100); lose 50% and the investment will need to go up by double or 100% just to recover the purchase price!
The more you lose, the tougher it is to even regain your cost price. We have seen such instances during the tech boom and financial crisis.
So what should investors do to avoid the big negative returns?
- Keep in mind preservation of capital and earning a ‘reasonable’ rate of return on that capital for a long period. Unreasonable growth is not sustainable over a longer term.
- Avoid fancied stocks and sectors which have already run up and are trading at expensive valuations. You only pay a fancy price for these and when it is no longer fancied by the market, you are left with a fancy loss.
- Look for bargains and good businesses which are out of favour, specially when momentum is strong and even bad quality companies see their prices soar.
- Avoid current fads if you do not understand them. Today, if you do not understand bitcoin and crypto-currencies, then it is perfectly fine to not invest in them. Do not have FOMO (Fear of Missing Out) just because it is scaling high.
- Avoid high priced Initial Public Offerings (IPOs) as these offerings come up in bull markets when the company can fetch the maximum price for its original shareholders/ promoters.
The feeling of being left out or regret is also strong during these times. If you keep hearing your friends and neighbours making money in the markets then one gets envious and wants to also participate. This leads to buying stocks on tips or without doing adequate research. This seldom works out well for the investor. Also, one needs to remember that people like talking about their victories. No one likes talking about their losses or failures.
Finally, investing should be about optimising returns instead of maximising them. To maximise returns one needs to take maximum risk. This can be extremely harmful when the tide turns. Optimising returns is when for the lowest amount of risk we get the best or most effective returns. This ensures we avoid permanent loss of capital and earn sustainable returns over the long term.