Losing Money is Easy
Too easy. While no one will say they want to lose money, many investors just can’t help themselves. They focus only on the short-term. They see trendy stocks going up, providing great short-term profits for other people, and they want their piece of the pie too. In short, they have FOMO – Fear of Missing Out.
Their FOMO is understandable. If big returns are out there, then why can’t they get them too? Of course, they can probably get them in the short-term simply by following the herd and buying the same stocks. What could go wrong, right?
Plenty. We saw a lot of people lose vast sums of money when the dot-com bubble burst in 2000. From 2000 to 2002, when the downturn reversed course, $5 trillion in total market capitalization was lost.
By the time the financial crisis of 2008 had run its course, $7.4 trillion in value was wiped out. The Dow Jones Index didn’t fully recover for four years, and many investors never invested in the stock market again.
Going Up, Crashing Down
It is said that stocks take the escalator up and the elevator down. Crashes and corrections can happen suddenly and catch investors off guard, leaving them panicked. When panic reaches a fever pitch, many people follow the herd, throw in the towel, and sell their stocks for whatever they can get for them – losing a lot of money in the process. Unfortunately, some people lost all of their savings during past large market corrections.
Did investors see the losses coming? A few insightful experts knew something was brewing on the horizon, but most people had no idea anything was wrong or they would’ve pulled their money out of the market.
Social Media Stock Tips (“Can’t Miss!”)
I recently spoke with a person who was looking for a new financial advisor in Los Angeles. She said that she wanted someone who could beat the S&P 500 by 5% every year. I told her that was unrealistic in the long-term, which should be her time horizon, not the short-term.
She also didn’t care that WealthArch’s composite performance outperformed the S&P 500 over the last 1 and 3-year periods as of June 30, 2024 despite keeping a lot of cash in reserve in case a large correction occurred. She told me that she didn’t want to sit on any cash and wanted everything fully invested.
I continued to tell her that if a large correction were to occur sometime in the next 5 years, it would be better to wait for lower prices before being aggressive, but she said there are people posting on X (formerly Twitter) who give 10 stock picks and those picks go up 20% per month. I didn’t bother researching who those people were because following those herds would likely eventually result in walking off a cliff. There’s a popular saying on Wall Street: “Everyone looks like a genius in a bull market.” But as Warren Buffett says, “When the tide turns, you know who is swimming naked.”
So, what is that person, and those like her, doing wrong? They are focused only on returns instead of focusing on risk-adjusted returns. Only focusing on returns without considering risk leaves a person susceptible to large losses when a mistake occurs or bad luck happens. As we saw in 2000-2002 and 2008, many investors lost more on the way down than what they made on the way back up.
Risk-Adjusted Returns
We spoke at some length about risk vs. reward in a previous blog post. It’s a good read, but some may find it a little too in-depth and technical, so I’ll keep this much simpler.
WealthArch’s focus is to find an investment that is undervalued to its intrinsic value. We go to great lengths to calculate how much we believe the company is approximately worth (valuation is never an exact science). We don’t use the over-simplified and misleading Price-to-Earnings (PE) ratio. Rather, we estimate a company’s future cash flows and discount that back to today’s present value.
Insight #1: Buying a stock below its intrinsic value helps us protect against permanent losses. This is different from maximizing returns, because our focus is optimizing risk-adjusted returns.
Stacking the Odds
At WealthArch, to stack the odds in our favor we patiently wait for the stock of a company we like to go below our intrinsic value estimate, and only invest in their stock when the margin of safety it provides is large enough to justify taking on that amount of risk. In other words, we only invest when there is a big enough buffer between the company’s intrinsic value and the current share price in order to absorb potential losses. This way of investing gives us the ability to have greater risk-adjusted returns with a lower probability of losing money.
Risk-Adjusted Return Example
One example from our “Investing Risk and Reward” blog post is if Stock A earned 10% per year compared to Stock B that earned 8% per year, then you would buy Stock A, right? After all, it made more money.
But what if Stock A had double the risk of Stock B? In other words, the odds of losing your money on Stock A were twice as much as what you could lose on Stock B. If that was the case, then we believe that Stock B is the better investment from a risk-adjusted reward perspective.
Insight #2: By focusing on downside protection, our upside is unknown. We think that is better than focusing on the upside where the downside is unknown and can lead to significant permanent losses.
To learn more about how we properly assess a company’s intrinsic value and price, please see our “Investment Approach” page.
If you would like to speak with Earl Yaokasin, CFA, our investment manager and financial advisor, please contact us.
