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January 25, 2017

Minimizing Risk Can Lead to Maximizing Return

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Writing in the Psychology of Human Misjudgment Charlie Munger describes what I think is a good way to think about financial matters.

First, I had long looked for insight by inversion in the intense manner counseled by the great algebraist, Jacobi: “Invert, always invert.” I sought good judgment mostly by collecting instances of bad judgment, then pondering ways to avoid such outcomes.

Avoiding drawdowns on your investments can be more important to achieving your financial goals than maximizing gains because markets tend to go up naturally over time. Staying in the game by preserving capital and avoiding catastrophic losses ensures you are in position to take advantage of the markets natural tendency to rise.

One of the more common pitches I’ve seen touting stock investments, especially passive ones. Is how much lower your return would be if you “missed” the ten highest return days of the market over a period of time. What if you avoided the ten biggest losing days though?

Typically, your returns would go up even more than the gain from the ten highest return days. And you still come out ahead if you miss out on the ten highest return days while also avoiding the ten biggest losing days.

Now you are unlikely to be able to execute on this example. The point is market losses tend to be steeper and more abrupt than market gains. So avoiding catastrophic losses is an important component of achieving your financial goals. After all if you lose all your money you can’t earn a return on it.

And if you lose a lot of your money it becomes much harder to achieve your objectives. If you start out with a $100,000 and aggressively invest it in investments that don’t work out. Losing $90,000 in the process so you only have $10,000 remaining, you’ve dug yourself a substantial hole. A 900% return is required get back to having $100,000.

This goes the other way too. You don’t want to avoid all risk or you’ll end up not earning anything on your money. Taking reasonable risk is the sweet spot for success. A 10% loss only requires an 11% return to get back to break even.

Continuing Munger writes

One very practical consequence of Liking/Loving Tendency is that it acts as a conditioning device that makes the liker or lover tend:

1) to ignore faults of, and comply with wishes of, the object of his affection,

2) to favor people, products, and actions merely associated with the object of his affection (as We shall see when we get to “Influence-from-Mere Association Tendency,” and

3) to distort other facts to facilitate love.

Where this tendency gets people into trouble with their investments is when they fall so in love with an investment they can no longer rationally evaluate it. Instituting a quantifiable sell strategy via a stop/loss is an important concept you can use to protect yourself from yourself.

Research indicates anywhere from 16% – 34% should work reasonably well depending on your tolerance for risk. Personally, mine is 25% right between the midpoint of the two. The key is to automatically sell no matter what your emotions are when a loss exceeds your stop/loss trigger.

For example if I bought something at $90 my stop would be 75% of $90, $67.50. If it goes up than I reset the stop. If it reached a $100 my stop would then be $75.

Instilling this discipline into your investment process ensures you capture the natural tendency for investments to rise over time. While ensuring you miss out on catastrophic drawdowns that could impair your ability to achieve your investment goals.

Want to obtain more of Charlie Munger’s wisdom. Check out The Psychology of Human Misjudgment.

Steve Miller
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Steve Miller

Founder at DebtMD
Steve is a CFA® Charterholder and founder of DebtMD.com. A site devoted to helping people discern insights into their finances. The CFA designation is globally recognized and attests to a charterholder’s success in a rigorous and comprehensive study program in the field of investment management and research analysis.

Steve recently authored Escaping Student Loan Debt to assist student loan holders with developing and implementing strategies to minimize their repayments.

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