When it comes to investing, the most successful investor, Warren Buffett, has just two rules: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” The simplicity yet importance of this quote is the reason why it is one of our favorites at Summerhill. Although the concept of not losing money may seem intuitive, the magnitude of a loss and the simple math associated with it will always be the number one impediment to creating wealth. The best money managers do not define themselves by the great companies they purchased, as much as by the companies they did not buy which did not perform well, avoiding losses that are difficult, sometimes even impossible, to recover from. This does not mean that the best investors, even Warren Buffett, never lose money. Of course they do. However, it is the magnitude of each loss that defines your performance in the future. It is also advisable to have well diversified portfolios in order to be able to offset the occasional setback.
It is important to note that there is an asymmetrical return profile between losses and the required return needed to bring you back to a breakeven level. We have termed this “The Investor’s Curse.” When an investor loses money, their remaining capital base has to work extra hard in order to recoup those losses because, after a loss, your capital base obviously becomes smaller. For example, if you started off with an investment of $1,000 and proceeded to lose 20%, your new capital base would be $800. Because of this lower capital base, you would need to earn a return of 25% just to get back to your initial investment of $1,000 [$800 x 1.25]. The mathematics of a loss dictates that a bigger gain is required just to breakeven: in this case a loss of 20% requires a gain of 25% to get back to breakeven. Consequently, the larger the loss (and therefore the lower the capital base becomes) the greater the positive return required to make up for lost ground. The graph below provides a visualization of this asymmetrical return profile. As you can see, the further along the x-axis you go, the greater the return required. A loss of 50% requires a 100% return; a loss of 80% requires a 400% return while a loss of 90% requires a highly unlikely 900% return to break even!!!
The consequences of losses are not limited to the requirement for bigger gains, as consideration also needs to be given to the time required to recoup those losses. The bigger the loss, the more time you will likely need to recover. This effect is illustrated in the table below which shows the number of years required to reach breakeven for a given level of losses and returns.
Clearly, recouping losses can require a significant amount of time. There is no better way to illustrate this than to look at some of our history’s biggest stock market declines and to see the number of years it took for the indices to reach previous peak levels.
We cannot stress enough the significant impact that negative performance can have on one’s portfolio. However, this isn’t to say that an investor will not have negative performing years, as often there are macro economic factors that will affect all securities regardless of their fundamental outlook, such as the majority of the downturns above. The only investor to our knowledge capable of producing year after year of positive performance, regardless of the markets in general, was Bernie Madoff, and we all know how that turned out. So yes, all investors will absolutely have the occasional negative performing year, and the important thing is to contain those to a minimum even in the worst environments (2008-2009 comes to mind), in order to ultimately recover and move forward.
So how then should one proceed when dealing with losses? The fact is not all losses are created equally. If a stock price goes down as a result of the general malaise of the market or the economy, this does not mean there is something wrong with this company or its intrinsic value. Likewise, if a company goes through a slower quarter because of a cyclical or one off event, or better yet because they are investing in the future of their business, this does not mean the stock should be sold immediately, even if the market which often cares only about the short term, slashes some of its value.
Also, from time to time, a stock price can get ahead of the fundamentals that support it due to strong optimism about its future intrinsic value. At some point, usually within the following year, it may fall behind even if nothing negative has happened within the business itself.
Understanding why a stock price moves down is crucial before making the decision as to whether it should be sold or added to.
In the end it is all about the quality of the companies themselves. If they are excellent businesses with strong competitive moats and above average earnings potential, corrections of any magnitude will all in fact be good buying opportunities, even if it will require patience before one is rewarded. But as the Summerhill portfolios reflect today, quality and patience always gets rewarded.
So the key to success in building your wealth is to limit your losses, so that they can be recouped within the following months or at worst over the subsequent couple of years. If you own quality there is no reason to panic and get out at the bottom, which unfortunately is the number one reason why most private investors lose money over the long term. Even in the worst of times, statistics will show that if you hold on for 10 years you have a 94% chance of positive returns, and over 20 years this number climbs to 100%. Even over 5 years, you have an 86% chance of positive returns if you analyze the market all the way back to 1926, which is factoring in some of the worst periods of all time as they include world wars, a depression an a great recession. Some times after a big crisis, there are multiple years of choppy returns but as the chart below shows, even then, if you know what you own, and it is high quality, it pays to stick it out.
The best investment performance does not come exclusively from securities that go up. It also comes from avoiding companies with such poor fundamentals that they drop to unrecoverable levels in the market. It means not exposing oneself to unnecessary risk no matter how attractive the return may seem to promise. It also means taking profits, when it has never looked better and waiting on the sidelines until the right opportunity comes up, which is often when things never look worse. But if the quality is there, all setbacks should be looked at as an opportunity rather than a moment to panic. Lastly, having some cash available in order to buy quality names during downturns is the absolutely number one way to create wealth. As the ultimate investment guru Buffett likes to say “Be fearful when others are greedy and greedy when others are fearful”.
The Summerhill Team