As frequent readers of this blog will recall, a key tenet of the Montaka approach is to protect our clients’ capital. In simple terms, we do all that we can to choose investments where we believe there is a low probability of loss; our number one rule is to not lose money. Framing our investment mantra in this particular way, rather than a converse focus on maximizing gains, is intentional, and there are a number of reasons, both psychological and financial, for being maniacally focused on reducing downside risk.

The psychology behind how we respond to loss vs gain

Humans are hardwired to feel a loss more acutely than a commensurate gain. This is called loss aversion, a concept identified by Amos Tversky and Daniel Kahneman. In other words, one who loses \$100 will lose more satisfaction than the satisfaction they would gain from a \$100 windfall. This is represented by the graph below, where the pain felt from a certain loss is greater than the pleasure we feel from an equal gain.

Source: Wharton Magazine

While investment losses are painful, the far more important reason for wanting to limit investment downside is due to the maths behind investment losses, and how deleterious they can be to investment performance.

The maths behind investment gains and losses

There are algebraic reasons why loss mitigation is crucial when managing a portfolio. Consider the chart below, which maps out what percentage gains are required to offset an investment loss.

Source: Swan Global Investments

If a \$100,000 investment goes up 10% in the first year, and then falls 10% in the second year, will you still have the same \$100,000 you started with? Unfortunately not. Your investment will appreciate to \$110,000 by the end of year one, and then fall to \$99,000 at the end of the second year. What if you were to lose 10% and then gain 10%? Again, you end year two with \$99,000.

The relationship between what investment gains are needed to recoup an investments loss is non-linear. If an investment were to lose 10%, then an 11% gain is required to return to breakeven. However, as the investment loss increases, the investment gain needed to recover the loss becomes exponentially larger. For example, a 50% investment loss needs a 100% gain, and a 90% loss needs a 900% gain to get back to breakeven! The takeaway from this is that investment losses hurt financial performance more than investment gains help it, particularly as the percentage changes become larger.

It is not worth risking your capital for investment gains if the potential loss is too severe. Warren Buffett once used a great metaphor of a gun with a million chambers and one bullet loaded in one of those chambers. His comment that was there was no sum of money that could persuade him to put the gun to his head and pull the trigger. The downside risk was simply too great.

When you combine the math behind losses with the proclivity of some investors to react to downturns and crystallize investment losses, it can result in actions that can truly hinder long term investment performance. Consider the following quote from Spencer Jakab, commenting on the investment track record of Peter Lynch:

During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return. But Lynch himself pointed out a fly in the ointment. He calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.

Investors should always keep in mind the outsized negative impact that investment losses can have on performance, and select an investment manager that has the same penchant for downside loss prevention. Avoiding these large losses is crucial, in order to allow the magic of compounding to take effect, maximizing the chances of long-term wealth creation.