David@valuealigned.com
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Ready for the next stock market crash?

After nine years since the last crash ended, can you afford even one devastating year?

The devastation to portfolios is often ugly when the stock market crashes. We have experienced two major market meltdowns in the last 17 years. One occurred between 2000 and 2002 when the S&P 500 index plummeted -49%. The other ran from October 2007 to March 2009 during the Great Recession, when the stock market fell -57%.

Imagine that your low-cost, diversified VanGuard index funds are down -50%. That means your retirement money in your 401(k) also suffers a -50% drawdown. It’s cut in half!

Now that’s painful, and will destroy your savings plan.

What do you call a market down 90%? It is a market that was down 80%, and then got cut in half from there. – Meb Faber

Most people believe diversification and asset allocation are effective ways to prevent the losses during such crashes. That strategy will fail again spectacularly.  Wall Street promotes “diversification” as the solution to the risk of horrible losses. But history shows it provides inadequate protection in severe market corrections and systematic financial crises.

Currently, eight years after the March 2009 market bottom, investors are pouring money into passive, low-cost index funds. They are putting their retirement savings on automatic pilot without any consideration to these periodic crashes. And worse they do not have a financial advisor who understands the risk to guide them. They just buy and hold and will do so all the way down until the pain’s too big when they sell near the bottom.

The Value of Avoiding Large Losses

Significant losses can be incredibly painful in the short term, but even more dramatic is the impact on the long-term success of investment returns.

Academic studies show the value of avoiding large losses, even as every investor’s common human behavioral biases trap him/her by frequently participating in massive losses. It doesn’t matter whether your investing style is passive or active, professionally managed or do-it-yourself (“DIY”), or high fee mutual funds or low-fee exchange traded index mutual funds (“ETF”). AS long as you are a human, you are prone to this devastation.

Most people are risk avoiders when making money or handling gains, and risk takers when losing money (Tversky and Kahneman, Judgment under Uncertainty: Heuristics and Biases, 1982). Losses hurt about twice as much as winnings are pleasing. It’s the urge you get to stay in an investment as its price goes down to make back the losses. The consequence is that investors don’t let their profits run by selling winners too soon. Instead, they let their losses run down by refusing to cut the losses before they get ugly.

The BIG problem is that the opposite behavior is necessary to be a successful trader or investor. You need to cut losses and let your winners run.

It is difficult for investors to avoid large losses because we are predisposed to let losers go down. And large losses usually occur much more quickly than the relatively steady gains achieved over many years. Fear and anxiety over losses paralyze investors as years of saving and patience are gone in a blink of an eye.

In the example above, you can see it takes nine years of +8% gains to double your money (The rule of 72 says money approximately doubles in the number of years that results from dividing 72 by the annual return―72 divided by 8 % per annum equals nine (9) years). But if your retirement fund goes down -50% in year ten (10) like it did for millions during the financial crisis in 2008, you would be right back where you started a decade ago. The annualized return over those years would be 0%, the real meaning of a lost decade for investors.

And it gets worse. Matching or beating the market is the wrong objective.

The graph below which comes from Crestmont Research and Swan Global Investments shows the winnings necessary to offset different losses. As the losses grow, the winnings or gains required to recover your losses exponentially increase, meaning that if you go down -50% you need +100%, a double, just to get back to even.

 

The graph shows that avoiding a loss is the same as capturing a bigger gain.

Wait a minute! Did Berk just say that “avoiding losses” can be better than “capturing even the average return?”

Yes, that is what I said. And that is why the Sage of Omaha, Warren Buffett, the greatest investor of all-time, and one of the top five richest persons in the world teaches us about investing by starting with these two rules: “Rule #1: Never lose money. Rule #2: Never forget rule #1.”

Wealthy individuals and their families around the world know this secret: Don’t focus on beating the market or the next guy. Don’t even target matching an index.

Although capturing positive returns is necessary to achieve your individual lifetime return, it is not nearly as important as capturing less of the downside, the losses, especially the enormous scary losses.

This chart from Crestmont describes the percentage of losses in down months you need to avoid (X-axis) matched with the portion of gains you need to capture (Y-axis) just to match the market return. If you lose only 20% of the market return in down months, you need to make only 40% of the gains in up months to match the market return. Avoid big part of the losses, and you can easily afford to get a smaller percentage of the market on the way up! You can underperform in the short-term when markets are going up as long as you avoid the BIG losses in the short-term.

Our strategy systematically uses this math. Capture a small percentage of the losses and gain a significant portion of the increase and you will earn your necessary lifetime return to meet your goals. Relative returns against the market index or your neighbor is not a life plan. First, you plan. Then you build the portfolio with the required long-term return that will earn your objectives.

Never judge the performance of your investments against something or someone else. Only judge your performance versus your unique plan. It’s quite literally just math.