How much do losses really hurt?

A lot.

Let’s find out why.

From a previous article I wrote – Drawdowns – Can they help you? – a reader (I must have close to 10 readers by now!) would know that the S&P 500 lost almost 60% of its value at the lowest points in both the dot-com crash in 2000–2002, and the financial crisis in 2008 –2009. How great does your return need to be following a drawdown of such magnitude in order to simply break even? Below is a chart that displays those returns.

numbers - drawdowns

 

The alarming thing is not that diversified indexes like the S&P 500 could drop 60% over a period of time (perhaps I’m just immune now to that type of pain). It’s that investors, with the click of a button, can invest in products that have a chance of dropping 100%. Most investors understand default risk when it comes to buying a single stock or a single bond from a company. However, oftentimes, when investors purchase mutual funds and ETFs, they believe that product is diversified enough to protect them from the large losses displayed in the above chart.

Let’s use oil as an example. If an investor back in 2007 said, “Hey, I’m pretty bullish about oil. I want to invest.” (Before you laugh, remember that most everyone was bullish about most everything back in 2007.) Watch, or read, The Big Short to find the dozen people in the world who were NOT bullish. Anyway, this investor finds a highly traded ETN (exchange-traded note) called iPath S&P GSCI Crude TR ETN. The price of this ETN peaked around 83.16 on June 30, 2008. Today, it’s trading at $4.80. That is a 94.23% loss. One may argue that there is no way the investor has stayed invested this entire time – I will concede that point. However, on February 27, 2009,  the ETN traded at 17.69. That is only around 242 days later and the investor already lost 78.73%.

Let’s go further. Say after falling to $17.69, a second investor thought, “Okay, we are through the worst. I think oil has been hit too hard. I want to invest.” This investor buys the ETN on March 31, 2009 at $19.09. I use the end of March 2009 specifically because  it is the month people say was the trough of the recession. Fast-forward to today and this second investor has still lost 75%! Even though this individual missed the worst part of the fall!

Another (just as realistic) scenario would be the NASDAQ Composite. Back in March 2000 it reached a high price of 5,132. By October 2002 it reached a low of 1,108. A drop of 78%. Having a large holding of stocks did not stop this huge drop.

Some emerging markets index ETFs dropped more than  70% during the financial crisis.

A 60% loss is almost the “realistic” worst case norm for “investment-grade” stocks such as Dow Jones Industrial Average and the S&P 500. However, once an investor leaves that arena, any loss is fair game.

I stress this is for two reasons. The first is that I myself was tempted to “play with oil” a couple years ago and I looked at this specific ETN. On June 30, 2014  it traded at $25.54. Technically, I earned almost 81% by NOT investing since that’s how much I would have lost if I bought the ETN at that level.

The second (and more painful) reason is that even sophisticated investors are not immune to flaws. Since we are in a “circle of trust” (right??) I will tell you about my worst investment. Back in 2014, I invested in a stock I believed was fundamentally sound. The financial statements were strong. Growth (both revenue and net income) was in the high double digit range. Return on invested capital was amazing. Debt was non-existent. Consumer confidence was high, and improving. The valuation of the stock was trading around, or slightly below, industry average. What was not to like?

I was so confident that I bought the stock outright, wrote a call option for a strike price 10% above the current price, and wrote a put option on it so that if the price dropped 10%, then I would buy more. After a month and a half went by and the stock had dropped, being the brash investor I was, I wrote ANOTHER put option on it. A month later, I had the first put “put” to me at $85. The next year and a half went in similar fashion. I continued to write put options, and have them put to me, and I watched as the stock bottomed around $35 last Friday. That is about a 63% loss. The recent drop of the S&P 500 saved my sanity as before the index had appreciated, but now it was in the red (accounting for dividends it was down around 1%…). What’s the saying – ‘Misery loves company’?

I think the most ironic thing was that I held on to about half of my original position (Yes, somehow I was able to muster the strength to liquidate half of the position over time) to avoid “getting out” at the bottom. However, on Friday I simply needed the funds for another investment and I was forced to liquidate….at the bottom. It has now gone up around 10%.

Simply said, it hurts.

I’ve made a number of great investments with real estate. Almost all the individual stocks I bought have gone up during their respective holding period. The great majority of the put options that I wrote have expired worthless. However, this one investment really sticks with me.

Interestingly, I’m still very confident about the company. The growth is still there, as well as the return on invested capital. The valuation is now half of the industry average as the company’s earnings have continued to increase – it’s just that other investors are now only willing to pay 8x its earnings, as opposed to 19x when I originally invested.

I would not classify the original investment as a mistake. The mistake, and flaw, was to not limit my investment to a specific percentage of my assets. The mistake was to continually invest more money into a single stock even after it had dropped 25%.  My conviction about the company impaired my decision-making.

Sophisticated investors, financial advisors, and portfolio managers are not immune to mistakes and flaws. The difference between the successful ones, and the “others,” is that successful ones learn from those mistakes.

As I said at the beginning, losses hurt a lot.

 

Adam McCurdy, CFP®, EA

 

As always, this if for informational and educational purposes. Nothing contained herein constitutes tax, legal, insurance or investment advice, or the recommendation of or an offer to sell, or the solicitation of an offer to buy or invest in any investment product, vehicle, service or instrument. What has worked in the past may not work in the future. Past returns do not guarantee future results.

Adam McCurdyHow much do losses really hurt?

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