Investing Myths: Gain Required to Make you Whole

Everyone knows Buffett’s rules number one and two, never loss money and don’t forget rule number one. They’re great rules and if we could apply more patience in our investing and weave in as many complementary rules like capital is scarce opportunities are plentiful then maybe we wouldn’t suffer many losses. My reality is that I incur losses and the same is probably true for you.

So how much profit does it take to recover from a loss? The following chart highlights conventional wisdom. The greater the loss the ever greater the gain required to make you whole again. For example a 10% loss only requires an 11%, a 50% loss requires a 100% gain and a 90% loss requires a massive 900% to make you whole again.

Scary stuff isn’t it? 10 baggers don’t come along very often.

As I said that is the conventional wisdom and one that is often used to promulgate stop losses and small position sizing opinions. I say the conventional wisdom is bollocks. It takes exactly the same percentage gain to make up for a loss. If you loss 10% it takes a 10% gain to make you whole. If you loss 90% it takes a 90% gain to make you whole.

Why conventional wisdom is wrong

Conventional wisdom is based on serial betting an entire stake. If you make serial bets (one after the other) of your entire stake then it does indeed take a 100% gain to make up for a 50% loss. Do you make serial bets of your entire stake? I doubt it. If like me you have a portfolio of stocks then you’re making parallel investments. If one investment losses 10% you are made whole by another similar sized investment gaining 10%. You never invest your entire stake in one stock, you spread your investment over many stocks.

Pull the weeds and water the flowers. Peter Lynch’s phrase was so good that Warren Buffett asked if he could use it in his annual report. While you may make a 100% loss on an initial investment, I know I have a few times, hopefully you’ll have headed Lynch’s advice and added to your winners. So your wins are magnified as they have more capital invested in them.

I’m not trying to encourage you forsake patience or forget the all important rule of never loss money, just realise that when viewed from the perspective of a portfolio some conventional wisdom is not so wise after all. Mental stop losses also make a lot sense in some cases and are almost essential for traders.

Long term investors, especially those investing in special situations, growth stocks or any other companies where major losses are a possibility should view their investments within the framework of a portfolio and cut their losers and let their winers run.

I’ll conclude with one of Peter Lynch’s 20 Golden Rules:

If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over the time you’re patient. You need to find few good stocks to make a lifetime of investing worthwhile.

If you want to read more then this post on position sizing is in a similar vein.

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13 comments

  • Dean,

    The convential wisdom you speak of does not make any assumptions, in fact I would not even consider it “wisdom” It is a simple mathamatical fact. 1 postion, 10 positions or 100 positions, bottom line is: as soon as you dust more than 40% of a portfolios total capital, recovering it becomes exponeitially difficult. Sure, conceptually you have outlined that losses for investors need to be considered in the context of a “total portfolio” but thats how the “conventional wisdom” has always been explained to me. This story is one about your overal capital not individual investment decisions.

  • Hi B
    I have seldom seen this “wisdom” applied to a portfolio, but recall scores of times seeing it applied to individual investments, in fact almost exclusively so. I’m glad that you have always had it explained as only applicable to a total portfolio and my post aimed to make sure that everyone else was conversant with that point.

    All the best – Dean

  • Agreed

    Cheers Dean

  • I think 50 articles on position sizing and loss points wouldn’t be enough on the topic so keep it coming Dean. The same idea needs to thought over again and again (in my case anyway).

    Position sizing, relationship to conviction and degree to which you could be wrong are actually very important in risk management.

    Personally I would not let a position be more than 25% of my portfolio even if I was 95% convinced. Because I tend to overestimate my conviction and it probably in reality translates to about a 75% probability after execution risk.

    Dean I have been watching DGX. It’s trading on a PE of ?2 after an earnings downgrade. What do you think ?

  • I agree that we need to have more ideas about portfolio management.

    For example, if you start out with 10 equal positions, and after 5 years, you end up with one stock taking up 50% of your total portfolio size, and that stock remains undervalued/fairly priced, and you have no other better alternative investment, what do you do?

    I have found that selling is the most difficult decision of all. Buying is easy.

    On a side issue, does anyone know whether TLS is offering bundled services? Given current issues with Vodafone network, and the large migration towards TLS mobile network, it is not too hard to give new customers a special bundled offering which incorporates landline, internet ADSL, and mobile phone in one package, with a two year contract? This will slow down the PSTN declines, and lock in sticky customers. I am still mulling TLS.

  • I have found that selling is the most difficult decision of all. Buying is easy.
    Peter, during his first few years at Magellan your name sake Peter Lynch was forced to sell whenever he wanted to buy, due to redemptions. That forced him to continuously sell companies he still liked, to buy something he liked better. For people who struggle with selling one approach is to run a 100% invested portfolio and sell/trim your least desirable companies whenever you want to buy a more desirable company.

    As to your 50% conundrum. It is difficult to talk in generalities as there are so many “it depends” at play. Though in general once a position become more than 15% of my portfolio I increase my hurdles for it and it becomes much more a question of whether I’d buy it at this price with those higher hurdles. So something that is fairly priced is likely to get trimmed. I also find trimming takes away the difficult emotional decision of selling. In general I prefer removing the all or nothing approach to investing.

    I’m certainly interested in continuing discussion. Dean

  • Thanks Dean. The problem with trimming is that you would be trimming the opportunity to hold a full position of multi-baggers eg CSL or COH.

    COH has been trading on an average of PE 20 and above in the last decade. From 1999 to 2007, it went from $10 to $60. Assuming I have 10 positions at 10k each for a total 100k portfolio in 1999, with 10k allocated to COH, and assuming all other 9 positions broke even, I would have COH at 60k, and total portfolio of 150k in 2007 (a dismal performance, I agree).

    COH then makes up 40% of my portfolio. So would you trim COH in 2007, and risk it on another stock? Remember that two decisions involving 60% probability of success for each will yield an expected probability of 36% for both to be successful!!

    Or am I thinking wrongly from a risk management point of view?

  • Hi Peter
    First up, on your probabilities, if you think like that you’ll never sell anything! What happens after you sell something is irrelevant so forget about that probability. Invert your logic, if you decided to hold your existing position rather than buy the new position you’ve made two decisions (decide to hold existing & decide not to buy new) with 60% probability of two independent events your expected probability is 36%!

    What you may wish to compare is your expected risk adjusted returns. You can risk adjust by different hurdle rates or assignment of probabilities. Going back to my earlier comment about increasing the hurdle rate (required rate of return) for larger positions you’ll soon find that it is difficult to hold on to all of a larger position.

    Going by bigcharts the P/E of COH.AX hit 40 in 2007. Considering its size I certainly would have been trimming it then, but that’s not your question is it.

    Another strategy that may help is considering what size position you’d buy at the current point in time. If it is significantly different from what you have then you might want to consider trimming it. Though you have to keep in mind that it is important to let you winners run. Is any of this helping, two beers makes me ramble a little 😉

    Let’s take ASW.AX. As you know I trimmed at $0.85. I again trimmed at $1.06 and $1.17, yet due to being a 3-4 bagger it is still a large position in my super portfolio. I consider it overvalued and if it was a medium-large cap stock I would have trimmed considerably more, but as it is a small cap which could easily grow into its valuation (though my tracking of their customer growth doesn’t make me overly confident about that) and go on to grow at 20% for a decade I’m prepared to hold a larger position that I would buy.

    Stepping back a little. I like to consider each company within the context of my portfolio. With your COH example at 40% of a ten stock portfolio, if the other nine were all equal weight then COH would be six times larger than any other position. I;d then consider whether I was six times more confident in that position that the others. There is of course the question of tax. It’s wonderful to get the free lend of owed tax from the government and that does wonders to compounding, so it is worth taking into consideration.

    I promise any further answers will be beer free, but I hope this was of interest nonetheless.

  • Hi Sean
    Property development companies are not in my wheelhouse. Are they in yours? I took a quick look at DGX.AX, it appears that they could do well or they could do very badly. I would not even consider P/E as their variability in return in great, 4.4c in 2009 HY and (.04) this HY. They’ve dropped the dividend this half. They’re small and highly leveraged. Do you know how WA property is developing, what the risks are in UAE? It’s simply is too hard for me to bother as I’d need to spend a week at least investigating it. If property is in your wheelhouse and you’re comfortable with my quick questions then please do give us a pitch.
    Hoop you partner and new babe are happy and healthy.
    Best – Dean

  • Hi Dean, I haven’t looked at it very carefully but was interested as it’s trading at near book value and for a developer, that’s not bad. Potentially there is ?0.04c/share in cash. The negative earnings last HY maybe due to real issues or lumpy development pipeline. In either case it was not forecast to the market adequately.

    I was hoping it would go to 0.12. Given that NTA about 0.2 from my guess that would be a reasonable margin of safety. Their accounts receivable is getting final payment on the properties. Their could be potential legal costs in extracting that in a stagnant or downwards trending property market.

    The DGX chart is ugly.

    On TLS. It also has an ugly chart. Yes tempting but it’s been in a downtrend since 2000. Is this time different ? I’ve bitten before and been burnt a few times so that’s tempered my enthusiasm. What is the probability that this is the actual bottom?

    bubba’s well, the big house is looking very tempting again. Keep up the excellent site.

  • Hi

    If anyone is really worried by a 90% loss requiring a 900% gain to recover I can offer a simple solution – learn more about how percentages work so that you then understand that they shouldn’t be used in this context.

    However great the reduction in a share price you will always need exactly the same increase to get back to the original price.

    All the best,
    Tired

  • Hi Tired, thanks for stopping by and leaving a comment. Can you elaborate on your comment that “however great the reduction in a share price you will always need exactly the same increase to get back to the original price.” When talking about one specific share I totally agree that it will take exactly the same dollar increase to make up for a fall, but in percentage terms it is the fall divided by the sum of one minus the fall, e.g. 90% fall requires 90%/(1-90%) = 900% gain to make you whole again. As another commenter said that is a mathematical fact, so I wonder if you are talking about dollar terms or some other concept in probabilities.
    Thanks again for your comment and I look forward to your response. Dean

  • Hi

    Yes, it’s a mathematical fact. But I’m saying that people are mislead when percentages are used to compare anything where the actual amounts are different. Of course a 10% reduction and then a 10% increase do not cancel out. But this is simply because the 10% increase is being calculated on a smaller figure.

    What if you wanted to warn somebody that hasn’t ever heard of percentages that it’s a really terrible thing – if you lose 6 dollars on a share then you would have to get a 6 dollar increase just to get back to where you started – isn’t investing difficult! And you warned the person that they won’t be able to sleep at nights worrying about how they could ever recover from the loss. They might think you were exaggerating the difficulties of investing. But then you might say “well I have this interesting misuse of mathematics that will really worry you”.

    If I temporarily lent you money – say 10% of what I have in my wallet at the moment, would I start worrying that you might not be able to pay me back because it would now have to be a higher percentage? Would I accept it if you thought it fair to increase my remaining cash by 10% a couple of hours later?

    Surely I would prefer to get the same amount in dollar terms back, rather than the same percentage. I think percentages – which are ratios – should only be used in the correct context.

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