Why it is better to lose small than win big
Imagine this: the year is 2014, and your diversified investment portfolio is earning a measly 7% while your neighbor Joe’s concentrated S&P 500 index is up over 14%(1). As if that wasn’t enough, Dianne, across the street, made a risky decision to buy stocks concentrated specifically in airline companies, and she’s all but doubled her investment (2)! So what gives? You’ve hired a financial advisor, and they don’t seem to be keeping up.
This is what behavioral finance would call recency bias and anchoring. These are two schemas that trick you into thinking that your neighbor's recent success is indicative of their investing acumen, and that their short-term returns translate into a long-term expectation, but when was the last time Joe and Dianne came to your door to tell you about their big loss? Anchoring your expectations to your friends and neighbors' “right place at the right time” investment strategy ultimately leads to heartache.
Individual investors tend to let emotion guide their investment decisions. When others seem to be winning, it’s only natural to want the same, but while our peers love to brag about “beating the market” short term, they rarely, if ever, admit when they make the wrong decisions. The statistics actually support that our friends and neighbors overwhelmingly make the wrong decisions. A 2021 study titled “Can Individual Investors Beat the Market” shows that individual investors only have a 10%-20% chance of making the right decisions (3)
Concentrated investing means big risk, and yes, it is true that big risk can mean big returns, but it also puts a lot of unnecessary stress on your investment dollars. Consider the charts below that navigate through 2020’s ‘Coronavirus Crash’.
This first chart shows the market at its high on February 19, 2020, down through the low on March 23rd, and back up to the recovery on August 18, 2020. In this amount of time, the S&P 500 had gone from 3,386 down to 2,237 and back up to 3,390 - a net rate of return of 0.11%
Now, let's focus on the high to the low. In just over a month, the S&P 500 had lost 33.92%. Let’s say you had started with a $100 investment on February 19. By March, that would have been down to $66.08.
So the question is: how hard does the remaining $66 have to work to earn you back your money? If you said “over 51%,” you would be right. Now, because of the big loss, your dollars have to work MUCH harder to get back to their starting point. Luckily, the S&P 500 had done just this, and by August 18, had returned 51.51%, as shown in the chart below.
Let’s consider for a moment that your neighbors only told you half of the story. Perhaps they were much more excited about the +52% gain and weren’t as eager to share the -34% loss they had recently suffered. Would knowing the whole picture change your perspective?
Imagine, then, a different set of circumstances. What if, instead of investing in just the S&P 500, you had bought a blend of different types of stocks and maybe even some bonds? Let’s say, hypothetically, you had only lost half of what the S&P 500 did over this period, and your $100 investment had only gone down by 17% to $83. How hard does your $83 have to work to break even? In this scenario, you’d only need 20.5% to get back to where you started.
Notice that it takes less than half the growth to recover from just half of the loss. In fact, if the hypothetical diversified portfolio that lost by half also grew by half, you would actually end up with a 25.76% return, which comes to $104.38!
To put that into perspective. By comparing statements with your neighbor over this exact same timeline, you’d notice that while their 51% recovery only got them back to their original $100 investment, your 25% recovery (from a smaller downturn) actually yielded a net positive outcome.
So the next time it seems like your day-trading neighbor has all the answers, take some time to review your financial goals, chat with your financial advisor about their investment philosophy, and remember that it is better to lose small than it is to win big.
1:https://seekingalpha.com/article/2791755-2014-s-and-p-500-return
2:https://www.kiplinger.com/article/investing/t052-c008-s003-the-10-best-stocks-of-2014.html
3:https://bpb-us-e2.wpmucdn.com/sites.uci.edu/dist/c/362/files/2021/07/Can-individual-investors-beat-the-market.pdf
Written by: Justin Meyer