A recent email exchange with someone who manages money professionally has lead to me to repost this piece I wrote some time ago. During the exchange I couldn’t convince them that not losing money was more important than trying to make it. It has always intrigued me how hard it is to get this point across to people. The notion of capital preservation along with only being in the market when the market tells you to enter are for me the two cornerstones of equities trading yet they are almost impossible to convince people of. And I am quite certain whilst I am up at the AIA Conference next week I will undoubtedly encounter more folks who simply dont get it.
The profession of trading or investing is an intriguing one . To the outside observer who comes from a discipline outside of finance or economics so much of what is taken for fact seems to be little more than half baked homilies that have been handed down from generation to generation. As with most narratives there seems to be scant evidence for things that are accepted as true.
Consider the chart below which has been taken from Funds Focus.
This image shows that if you had missed the best days in the All Ordinaries Accumulation Index for the period quoted that your performance would have dropped dramatically. The implication is therefore that you should stay continuously investing. In most cases this sort of image is used as justification to simply buy and hold. Such images are standard fare in both financial planning and funds management marketing. The market and the time period may changed but the basic message remains the same.
As initially compelling as this image may be it doesn’t actually convey the entire story of investing in a market. To get a sense of the entire story you need to look at the notion of worst days – what happens to your returns if you set out to manage your exposure to those periods when the market begins to swing down.
The notion of missing days is extremely impractical since it requires a remarkable fidelity in ones timing strategy. However, it is possible to generate techniques that can miss the worst months that a market may go through. The chart above looks at what happens to returns if you have missed those periods where the All Ordinaries Index went down 2.5% or more versus being in the market when the market climbed 2.5% or more. For the period quoted if we had missed the so called good times our return would have been -83.26%, if we had simply held the index our return would have been 91.71%. If we stopped the investigation at this point it would seem to justify the notion of being in the market all the time since being out of the market had damaged our return. Yet, this is not the entire story because if we had missed the bad periods our return is 3079.50%.
The reason for this difference in return is simple. Losses matter more than gains, a 10% loss cannot be made up by a 10% gain – it takes 11.1% to return to your starting point. The unyielding harshness of this can be seen in the chart below.
All good traders know that that the preservation of capital is far more important than the making money. It is also one of the few things within that control of traders. The return we generate is dictated by forces outside our control but we can control how much is lost on individual positions. We can only make whet the market is willing to give us but we can decide how much we are willing to lose on any given investment.
The differential I generated between missing good periods and bad periods is unrealistic but it does serve to illustrate that the notion of being in the market all the time is extremely flawed and in part is explanation for the appalling rate of return of domestic fund mangers. What is of more importance to those investing in markets is to understand that losing money is more important than making it. Trading or investing is largely about being able to play a good defence. There are very few absolutes in markets but one thing is clear. If you have no money you cannot play and whilst being seduced by some of the childish homilies that abound in markets might not send you completely broke it will guarantee that your returns are ordinary.