-By Charles Brown, M.Brown Financial Advisors
-June 29, 2023
Daniel Kahneman and Amos Tversky, pioneers of behavioral psychology, studied how losses affect individuals. Their studies concluded that the pain of losing money is about twice as much as the pleasure of gaining that same sum (this phenomenon is called “loss aversion”). Losing is painful. One way to make investment losses more painful is to “dollarize” those losses.
Let’s take an investor who invests $500,000 in stocks. Over a 6-year bull market with minimal volatility, his original investment is now worth $1 million (roughly a 12% annualized rate of return). This investor experiences a 20% bear market in year seven. His account is now at $800,000 which is still a respectable 6.5% annualized rate of return.
Are we happy or upset with this outcome? I would bet some investors would be devastated with losing $200,000. That $200,000 represents 40% of the original investment value. It also represents a Ferrari (used maybe?), a down payment on a vacation home, kids’ college and many other material things that mean a lot to us. And now it’s gone.
Portfolio drawdowns in percentage terms give us an unbiased look at how far away we are from our high-water mark. Changing that percentage into a dollar amount adds an emotional element to the investments that will make the losses harder to take. The harder they are to take, the greater the odds of the investor selling everything and failing to let the capital compound. You will have better investment outcomes and make better investing decisions by minimizing the emotions involved with dollarizing losses.
Calculating Losses from a High-Water Mark
Continuing with the above example, how else did the investor make things harder on themselves? They focused on the loss amount from the high-water mark and not on the bigger picture. This investor just MADE $300,000 in seven years – that’s huge! Of course the dollar value of the losses is large, that’s because the account grew to a much larger number. We should expect to lose 10% to 20% on our stocks from time to time – it happens (see the chart below* – also see Thinking About Losing Part 1). As long as this individual is not headed into retirement tomorrow, they have time to get the losses back and potentially turn the $800,000 into $1,600,000 with a similar bull market.
If you are a long-term investor, the next big market downturn is always going to be the biggest in dollar terms. If this investor turns the $800,000 into $1.6MM then the next 20% bear market will bring a $320,000 loss. If the investor can double his money again, then the next loss would be $512,000 on a $2.56MM account balance.
It’s easy to look at the absolute top in your account balance and say that you should have sold out at that point. If you did, then you wouldn’t have lost “x” dollars. But you also NEVER know when that 20% or greater selloff is coming, and selling early could mean missing big gains. We know from the chart in example 1 to expect losses, but the timing of those losses is unknowable. Calculating losses from a high-water mark is a way to focus on the negatives of investing and implies that you can see the future – which you can not.
Looking at the bigger picture helps you to stay the course. An investor can turn $500,000 into $2MM in 20 years with a 7% rate of return. But to get there, the investor needs to STAY invested though various market swings. Investors have a better chance of staying invested if they understand that losses are part of the game. Not calculating losses from a high water mark and not dollarizing losses will help to keep emotions in check during what will inevitably be a volatile investment journey.
*Chart from Carson Investment Research and @RyanDetrick on Twitter
**The above article is informational in nature only and is not a recommendation to buy or sell securities. All information is gathered from sources believed to be reliable, but neither Charles Brown nor Ausdal Financial Partners, Inc guarantees the accuracy of the information. All investments carry a degree of risk. Individuals should consult with their tax and investment professionals before making changes to their investment portfolios.
***Securities and Advisory Services offered through Ausdal Financial Partners, Inc., an SEC registered investment adviser, member FINRA & SIPC. 5187 Utica Ridge Rd., Davenport IA 52807, 563-326-2064, www.ausdal.com. Sub-advisory services offered through M. Brown Financial Advisors, a registered investment adviser with the state of Illinois. M. Brown Financial Advisors is located at 2728 Forgue Drive, Suite 100, Naperville, IL 60564, 630-637-8600. M. Brown Financial Advisors and Ausdal Financial Partners are unaffiliated entities and only transact business in states where they are properly registered, or are excluded or exempt from registration requirements. Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission or any state regulators. Ausdal Financial Partners, Inc. does not accept buy, sell or cancel orders by email, or any instructions by e‐mail that would require your signature. Information contained in this communication is not considered an official record of your account and does not supersede normal trade confirmations or statements. Any information provided has been prepared from sources believed to be reliable but does not represent all available data necessary for making investment decisions and is for informational purposes only.