No investor can expect to avoid losses throughout their investment career. However, there are steps you can take to reduce the chances of losing money on your holdings.
One investor who has a successful track record in risk management is Oaktree Capital founder Howard Marks (Trades, Portfolio).
His ability to ignore emotions, obtain a margin of safety and respect previous economic events are key reasons for his long-term outperformance of the stock market.
History repeating
The stock market’s performance is never an exact copy of the past. However, it can be similar. Investors who embrace this concept can reduce their chances of experiencing losses.
For instance, the stock market has never experienced a permanent bull market or a permanent bear market. It continually switches between them. Therefore, value investors can reduce their risk of loss through avoiding overpaying for stocks during a period of rising prices.
This may mean they miss out on short-term gains as stocks can become further overvalued. However, they can avoid losses over the long run through purchasing stocks that are priced favorably.
As Marks once said, “Every once in a while, an up-or-down-leg goes on for a long time and/or to a great extreme and people start to say 'this time it's different.' They cite the changes in geopolitics, institutions, technology or behaviour that have rendered the 'old rules' obsolete. They make investment decisions that extrapolate the recent trend. And then it turns out that the old rules still apply and the cycle resumes. In the end, trees don't grow to the sky, and few things go to zero”.
An analytical focus
Investors who rely on facts and figures, rather than their emotions, may be able to reduce their chances of experiencing losses.
It is easy to listen to your emotions when share prices are rising and when they are falling. For example, in a bull market, you may become greedy when searching for high returns. This may mean you end up paying a high price for stocks that provide limited scope for capital gains.
Likewise, in a bear market you may become fearful about the paper losses experienced in your portfolio. This could cause you to sell stocks at low prices that do not take into account their recovery potential.
Therefore, focusing on company fundamentals and judging whether stocks offer good value for money or not could be a more prudent approach to apportioning your capital. It may not only help you to avoid losses, but to also maximize your long-term gains.
Marks has previously highlighted the unhelpful role that emotions can play in investing: “The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”
A margin of safety
The stock market’s short-term price movements are impossible to predict due to the number of unknowns that can affect stock prices.
Therefore, even if an investor is able to identify a sound business that offers long-term growth potential, buying it may not produce the desired level of return due to the risks present.
One means of reducing the potential for loss when buying stocks is to demand a wide margin of safety. This is where a stock is purchased for less than it is deemed to be worth by an investor, which provides a "buffer" in case risks end up hurting its financial performance.
Demanding a margin of safety when buying stocks may mean that you miss out on some quality businesses that ultimately deliver attractive returns from a high starting point. However, it will help you to avoid those stocks that do not offer attractive risk-reward opportunities, and that could produce large losses.
As Marks once said, “Risk is incredibly important to investors. It’s also ephemeral and unmeasurable. All of this makes it very hard to recognize, especially when emotions are running high. But recognize it we must”.
Read more here:
- Peter Lynch on Why Intelligence May Be Overrated
- Benjamin Graham on Speculating Versus Investing​
- Buffett, Klarman and Graham on Taking Advantage of Market Uncertainty
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