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  • Eugen Neagu

How not to lose your shirt when investing?

Investment losses are not only an emotional problem, but also an objective one, because investors have financial objectives which they would like to achieve when investing.

Determining your probable maximum loss and designing a portfolio with an equity asset allocation that is consistent with your decision could allow you to control your maximum drawdown. How much of your investment portfolio you can afford to lose is one of the most critical questions investors and their advisors need to ask themselves.

Volatility is not something that will bother most investors too much during bull markets. This is one of the reasons investors could be attracted into taking on additional risk as stock markets rise. Sometimes, especially when investing without an agent, do it yourself (DIY) investors are attracted to invest in more speculative stocks which tend to lead the market up during rallies, but collapse in down markets. There is also the problem of correlations, which as evidenced in 2023, have become very high due to a few companies (sometimes named the M7 – the seven magnificent), which are responsible for the whole return of U.S. equity index, and to the MSCI World index.

The following chart exhibits the challenge of making your investment back after you lose it. Notice that the more you lose, the amount you need to break even grows exponentially.

Avoiding investment losses is important!

Portfolio volatility by itself greatly reduces your returns. This is because the money lost is capital that is no longer available for investment. If you lose only 10%, you still have 90% of your capital available for investment. If you lose 50% you only have 50% of your capital available for investment, so a 100% gain is required to get back to break even.

When you experience large losses, you have less to invest and then your portfolio is in a position that can take many years to recover to break even. The reality of breakeven loss analysis makes losing 50% of your money intolerable! After losing 50%, IF the market gained 10% per year, and you were 100% invested, it would take 7 years to get back to breakeven.

Bear Markets

Bear markets are a part of investing. Over the last 200 years we have experienced a financial crises every 4-5 years on average. Periodically we experience bear markets that last as long as 20 years.

You must preserve most of your capital in bear markets to be a successful investor! This is where many investors experience failure. Over the years I have known people who were exuberant and were achieving higher rates of return, only to have their portfolio destroyed in the next bear market. Many investors have been taught the outdated buy and hold strategy that causes them to sell in bear markets. This is because they would get to the point, they cannot stand the pain of a bear market anymore and they would break the “buy and hold” rule, often selling at the point of maximum opportunity!

Since 1900 there have been 5 major bear markets, some of them lasting MANY years including a devastating 81% decline from Sept 1929 to June 1932.

Major Bear Markets (inflation adjusted): 1906 – 1921 = 69% decline 1929 – 1932 = 81% decline 1937 – 1949 = 54% decline 1968 – 1982 = 63% decline 2000 – 2009 = 59% decline

A better way to invest!

Our process starts with choosing a maximum probable loss for equities. Based on recent history when Central Banks have started to employ a new tool (quantitative easing to buy assets) we decided on 45%. We think we can do better than that by using “value” investing, having equity portfolios with low allocation to cyclical sectors, and most of the equity allocation tilted towards defensive and sensitive sectors.

On top of that we outlay our own valuations metrics to determine if a sector is cheap or expensive. We also pay attention to leverage, as we want our companies that we ultimately invest in to have a lot lower leverage than the market. This is one of the reasons we avoid financials and Real Estate Investment Trusts (REITs), with the only exemption is buying them extremely cheap at the bottom of the recession, and holding on them for no more than one year afterwards.

By doing that, we expect to participate less than the market in bear markets, around 2/3rds instead of fully or even more, so our maximum drawdown for our equity exposure to be around 30%.

We then choose the maximum loss we will accept in a portfolio, which for most of our clients is 20%. This is mathematically determined* to allow the portfolio to recover quickly to its initial value and to push forward through the next economic cycle.

As a result, the maximum equity allocation we would have at this moment is 67% for a client who is within the “fragile” period, which usually starts at age 50 for someone willing to retire from 57 to age 62.

Even more important care should be taken with the other 33% allocation left. Again, paying attention to valuations is very important as investing in long duration bonds when interest rates are 0.5% to 2% per annum makes no sense whatsoever. As in 2022, there could be periods of higher inflation which will need to be tamed, and Central banks would need to raise the reference interest rates. As explained in a previous article, interest rates act like gravity for all asset classes, with very little exemptions (in 2022 - Oil and gas, consumer staples and energy producers were the exemption).

However, in many bear markets, the corelation between very high investment grade bonds (usually Government bonds) and equity is negative, as Central Banks would reduce interest rates and print money (quantitative easing) to restart the economy. We would rely on this for the next bear market, but we will keep bond duration quite short.

IMPORTANT NOTE: The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.

Copyright N2 Asset Management Limited

*This will be subject to another article.


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