We Fear Investment Loss. This Is What To Do About It.
As financial freedom nears, we become acutely aware of big losses in our investment portfolios. Can we control how much market crashes hurt us? Contrary to popular belief, we can. This is the first of four posts that will show you how.
A big investment loss is like an unexpected, steep hill when biking. It takes more than you think to overcome. Photo by Coen van de Broek on Unsplash
This post is part of a 4-part series about smart investing for the semi-retired.
Controlling investment loss is key (this post)
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It’s been a busy Saturday at the soccer fields. You’re driving home when you need to pull over to let the fire engines pass. Gosh, those sirens are loud. Two blocks further and you turn onto your block. There’s so much commotion. Then you realize it. Your house is the one on fire.
Losing a home to fire is emotionally catastrophic. But it doesn’t have to be financially catastrophic. Because we insure such a large investment. We control for possible loss. And we sleep well at night because of it.
We are quick to insure our $500,000 or $750,000 home. But then we do nothing to protect our $1,000,000 or $2,000,000 investment portfolio.
Let me rephrase.
What if your life savings- built over 25 years of working hard and living below your means- were cut in half? Imagine that you’re 5 or 10 years from retirement. How would you feel if your savings fell by more than 50% then took 13 years to recover?
This happened in 2000.
The S&P 500 reached its all-time intraday high during the dot-com bubble on March 24, 2000, at 1,552.87.
It declined 56.4% from its peak to its low on March 9, 2009, at 676.53.
The S&P 500 recovered to its pre-crash high on March 28, 2013, roughly 13 years later.
A 0% investment return over 13 years would change your retirement plans.
Yet, we kind of…just…ignore the possibility of big losses like this. Why?
It’s not loss aversion!
Daniel Kahneman and Amos Tversky popularized the rule of loss aversion. It states:
“The psychological pain of losing is about twice as powerful as the pleasure of gaining.”
We feel worse after a loss than we feel good after a win. I’ll bet it feels right to you. It does for me.
Five years ago, I could see financial freedom getting close. I would soon live off my savings and investments. This was new for me, and the fear of loss kept me awake at night. It got much worse during the COVID crash in the spring of 2020.
So, if loss aversion should prompt us to do everything we can to stymie loss, why don’t we?
It’s because loss is private. It’s not shared. We handle any loss, investment loss included, with quiet shame. We deal with loss alone. We try to ignore it. And this makes it hard for us, as individual investors, to want to study it.
Ignoring loss goes even deeper. Financial advisors, who we entrust, don’t like to talk about loss either. It’s not a hopeful message. It’s much easier to talk about gains! (And it makes a better sales message, too.)
We Ignore Losses
We’ve heard of the so-called “8th Wonder of the World.” The phrase that describes compound interest is often attributed to Ben Franklin or Albert Einstein (neither confirmed).
When I discovered compound interest, I thought I had received a secret gift: “Start saving early so you can compound over many years. Get rich without even having to work…”
We’ve seen those charts and graphs showing incredible, exponential growth from compound interest.
How to win at investing is well covered.
How not to lose at investing is not.
I learned about compound interest at eight years old. But I learned how to manage investment losses 35 years later…long after I began studying personal finance and investing. Why?
Ignoring losses goes beyond financial advisors shunning them. It extends into the do-it-yourself crowd, too. (This is me.)
The messages I heard discussed losses, but in a way that conveys you have no control. See if you recognize them
“Invest for the long term so you can recover from losses.” In other words, wait for losses to recover. Not very helpful. But it gets worse.
“You only lock in losses if you sell.” I don’t know about you, but I still feel poorer when my portfolio is down 30% despite not locking in my losses. Don’t sell when down is the advice.
“Our favorite holding period is forever.” Warren Buffett said this of his buy & hold investing style. Buffett does sell stocks. But he prefers long-term investments over short-term trading. I misinterpreted his advice when I first learned it. I took it to mean never sell.
So, let’s learn more about controlling losses.
Loss Asymmetry Defined
The lesson is simple yet powerful.
“Investment losses and gains are not equal in impact. If an investment loses some of its value, it requires an even larger gain to return to its original value.”
In fact, the math behind losses is brutal.
Here’s a simple example to illustrate it:
When asked what gain you need to recover from a 50% loss, most people will answer a 50% gain.
But, if you lose 50% of your savings, your savings are now half their original value. To get back to the original value, your reduced savings now need to double — which is a 100% gain.
This asymmetry is critical to understanding why you should avoid large losses!
Biking Hills Analogy
I go road biking on Saturday mornings. All my thinking about investment loss led me to an analogy…that came to me as I rode last weekend:
Imagine yourself pedaling along, maintaining speed on a flat road. You suddenly and surprisingly encounter a hill. In your shock, you stop pedaling just for a moment.
Many of us think this:
After realizing what happened, you start pedaling again like you were. But this doesn’t help you recover your original speed.
The actual case is this:
To fully recover from the setback of your surprise, you need to pedal even harder than before. You need to regain your speed and overcome the hill.
The hill is like a surprise investment loss. (They are all surprises, am I right?) Our goal, then, is to keep the hill’s steepness to a minimum for easier recovery.
For example, there is one hill where I ride in Oakland. The street name is Hiller, believe it or not. If I stop pedaling for a moment, I can’t recover. I need to walk my bike…it’s that steep. (I’ve tested this…and not on purpose.) I’m wiped out.
Recovering from loss is so hard that we should try to avoid them altogether.
Even the professionals agree. Warren Buffett also said,
“My first investing rule is not to lose money. My second rule is never to forget my first rule.”
Buffett is emphasizing the importance of avoiding losses when investing.
What Do We Do (and How)?
This table shows the gains required to recover losses ranging from 5% to 90%. As losses steepen, the pain accelerates.
Loss asymmetry table. Beyond a 25% loss, recovery percentages accelerate.
The lesson here:
“Don’t lose more than 20–25% of your portfolio ever.”
It’s simply too hard to recover. You’ll find yourself on Hiller Drive in the Oakland Hills. Severe losses really set you back. It’s math.
The solution: We need to follow the math and sell falling investments to protect ourselves from even steeper losses.
We do it with sell criteria.
But it’s easier said than done. Individual investors typically have no sell criteria. I didn’t. Do you have sell criteria? Probably not.
We often ignore sell criteria due to a combination of behavioral factors:
We attach our emotions to certain stocks, especially if chosen based on personal beliefs or biases.
We are reluctant to sell at a loss, hoping a stock will recover to at least break even.
We overestimate our ability to pick winning stocks. We hold onto them longer than advisable, thinking they will rebound.
We experience analysis paralysis due to information overload and can’t decide when to sell.
We’re influenced by what others are doing and hold onto stocks because others are.
But mostly, we have no well-defined investment strategy that includes selling. We have no predetermined criteria for when to sell, leading to poor decisions.
And that’s what we must do: Use a proven strategy that sells investments when mathematical models show it is time.
Once you do that, you’ll sleep better at night. Zzzzzz.
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Brian Herriot road bikes and invests from his home in Alameda, California, and cabin in Hazelhurst, Wisconsin. He also prepares financial freedom plans for consultants and other mid-career professionals in one-week sprints. Check out his take on a new and different kind of retirement at choosyconsultant.com.