Wednesday, May 29, 2013

The Cost of a Loss

We've all heard Warren Buffet's rules for investing.

Rule 1: Don't Lose Money

Rule 2: Don't Forget Rule 1

No investor ever wants to lose money because not only did they just lose money, but it's a validation of the fact that they were wrong.

Just how bad is a loss and how long does it take to get back to even?



As you can see in the chart, it'll take almost 5 years just to get back to the original amount if you are able to then earn 15% per year after the loss.  A more realistic number would be that you could earn 7% per year after the loss.  This would require over 10 years to get back to the original amount.

Here's another way to look at it based on required total return going forward based on different loss percentages.


Of course, this is just to get back to the original amount in nominal terms.  Assuming that it would have been earning a return would just push the break-even point further back.

You can use the following formula to calculate the number of years to get back to the original amount, where P = original investment, L = % loss, R = rate of return going forward, and n = number of years

The top formula is the beginning equation and the bottom equation has been rearranged to solve for the number of years.

I have created a spreadsheet where you can run your own numbers that you can access here.

Since making up for a loss requires several years at an average rate of return, this is why I prefer to use dividend growth stocks.  In general they are more stable companies that have been through multiple economic cycles, coming out stronger through each one.  Not only are dividend growth stocks typically more stable, but you are receiving something tangible from them, the dividend.  Dividend payments will provide a return, even in the darkest times of the stock market or economy and will help to keep you invested instead of turning your back on the markets during the best time for net purchasers of stocks.

This also reinforces how important your purchase price is.  The right purchase price will provide better returns going forward as well as allow for a margin of safety between the true value and your purchase price.  I've been building my cash position recently in order to avoid overpaying for my investments.  Most stocks that I'm interested in aren't grossly overvalued but they are higher than what I would like to be paying for them.  Eventually the markets will turn again and provide opportunities to further increase the dividend stream from my portfolio.

I'll end with another nugget from Warren Buffet, "Price is what you pay, value is what you get."

14 comments:

  1. Making up for a loss also speaks to why you should be diversified over an array of equities. If one position out of 30 or so goes to zero, it'll only take a year or so to make up the loss.

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    1. MyFIJ,

      Definitely agree on that one. While a concentrated portfolio should yield better results because it's easy to come up with 10 great ideas, 30+ though is much more difficult. But to me the risk is too large for the reward. I'd rather have the comfort of knowing that if one or two of my positions goes belly up, my portfolio isn't completely screwed.

      Thanks for stopping by!

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  2. When it comes to investing, the Buffett approach is best. Rule number one is to not lose money. Rule number two is to not forget rule number one.

    I like that rule, "don't lose money". Although some people apply it very wrong. By not losing money, that doesn't mean to have your money in a mattress, but it means that you need to invest with a margin of safety, because bad things will happen if you do not. What Buffet meant by that was buy quality companies at a fair or attractive price.

    Good article, take care.

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    1. Exponential Dividends,

      Stuffing your savings under your mattress is still losing money thanks to inflation. The total will still be there 10 years down the road but it'll be worth much less.

      Having a margin of safety has been the best concept that I've learned. It allows for any analysis you've done on the company to be wrong and you can still have a gain.

      Thanks for stopping by!

      Delete
  3. I wish never losing money was an option. I think the most important thing is not to compound a loss by holding onto a bad investment hoping that it will recover just because you don't want to take a loss on it. Sometimes it's better to dump a loser and "recover" in a totally different investment.

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    1. First Million,

      If only that was an option, of course we'd all be millionaires if it was. Knowing when to cut your losses on a bad investment is just as important as knowing when to purchase a different investment. It's important to not get emotionally attached to your stocks and to take notice when things change at the company or any investment.

      Thanks for stopping by!

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  4. Losing money really sucks... and you never forget it. But it's also important to not let one bad experience deter you from making future moves. I love dividend stocks, but also like to gamble a little bit and invest in hyper growth stocks (which are much more likely to burn me). I jumped onto the AAPL bandwagon too late and took quite a beating, selling for a loss. So, you definitely make a good point in buying at the right price. Sometimes it's hard to know, though. For instance, had I decided to stay away from growth stocks b/c of risks + "bad" valuation, I never would have invested in TSLA, which is also risky and fundamentally unsound. But being too gun shy might also prevent you from capitalizing on one of those "once in a lifetime" growth stories.

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    1. FI,

      Admitting you made a mistake is hard to do but a necessary step in the process. Until you do you can't start to try and fix the situation. I think there's a place for growth stocks, especially in a younger person's portfolio, however it's important not to go all out with them. I wouldn't be comfortable having even half my portfolio invested in traditional growth stocks, oxymoron much? I think the risk in doing so outweighs the potential reward. I think if you want to go with a larger allocation to growth stocks then you need to be more diligent about taking some profits off the table at different stages of the game. If it gets to where you've taken all of your investment and then some out then letting the house's money ride is much easier to take a loss on.

      Thanks for stopping by!

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  5. I HATE losing money on an investment. When I look at my losses, I always thought that I would have been better off buying a certificate of deposit and feel happy about my 3% yield!

    I'm now a more disciplined investor and follow my guidelines. Each time I buy a stock according to my own investing rules, I make money. The key is to sell when you make money and continue to purchase other stocks to grow your portfolio :-)

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    1. Dividend Guy,

      Luckily I gravitated towards DGI early on in my investing career. I'm about like you where when I trust my analysis and follow my investing rules, one of which is to insist on a margin of safety, then I end up in the black.

      I still haven't worked out how to capture profits because almost all of my gains so far are just on paper. With the core of my portfolio I don't think I'll be selling unless they get grossly overvalued 25 or 30+ PE ratios, there's just now way the growth can justify those prices. If you don't mind me asking what kind of rules do you have for selling stocks?

      Thanks for stopping by!

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    2. Hey PIP,

      As any good DGI should do; I would sell if there is a dividend cut ;-)

      I follow quarterly results and make sure the reason I bought the stock in the firs place are still there. I also ask myself if I would buy the stock again today if I hadn't any shares. If the answer is no or uncertain, I'm putting a stop loss to protect my profit.

      This is what I did with STX after a paper gain of 65%. I've put a stop loss at $40 when it was at $42. The stock dropped to I sold my shares. Even thought STX is back over $43 (as of May 31st), I don't regret my decision. I've made a healthy profit on a highly volatile stock evolving in an unsure market where sales are slowing down.

      Sales trend is a strong indicator. If your global business model doesn't allow you to grow your sales (it's hard to sell more hard drive when PC sales continue to drop), then it will be hard to make more profit and increase your dividend.

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    3. Dividend Guy,

      Got to agree with you on the dividend cut triggering a sale or at least very serious consideration for it.

      I'm assuming by whether you would buy the stock again, that is just referring to the underlying company and not necessarily the valuation. Because there's several companies I would love to be buying but not at the current valuations. I sold out of WM a little while ago because I don't like the dividend growth prospects and have been very disappointed with the last 2 increases. A 2.5-3% growth rate from a current yield around 3.50% just doesn't do it for me. I had purchased for much cheaper and locked in a solid gain though.

      I do like to follow revenue and revenue growth. They are the first step towards any company being profitable. If anyone thinks revenue isn't important just tell them to go research any of the dot com companies with ridiculous valuations despite zero to no revenue.

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  6. In addition to the financial impact of a loss, I think the psychological impact is more problematic. It gets you rethinking your strategy and whether you have followed the right approach. That can really mess you up. In general with dividend growth investing, that problem is largely mitigated in my view. No revenue, no earnings, No cash no dividend. You have then largely avoided some of the principal reasons for financial loss and why companies go under.

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    1. Integrator,

      I agree that the psychological impact is the bigger worry here. The thing I like best about keeping the blog and posting about all of my purchases is that I have a record of the reason I purchased in the first place. If I end up taking a loss on a position then I can go back to reanalyze what it was that I missed in the first place. If you're changing your strategy because of a loss then I don't think you'll be a great investor. You'll just end up changing again in the future, because a loss is inevitable. No one's going to be right 100% of the time. As a DG investor it's a bit easier to see a position in the red as long as the dividend and prospects for growth of the dividend remain sound.

      Thanks for stopping by!

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