A few years ago, I was reading a reputable financial newspaper*, when I nearly choked on my doughnut. I have lost the link to the article, but it said something along the lines of:
Stockholders will be happy: Shares in XYZ Bank have soared by 40% this year, more than making up for the 30% loss suffered last year.
Sounds reasonable, doesn’t it? 40% is bigger than 30%, isn’t it?
Like hell it is.
This is surprisingly often misunderstood. Consider owning a share costing $100. It falls 30%. How much is it worth now?
$100 x (1 – 0.3) = $70.
Cue sad face, and perhaps even a violin. Except that it now rallies 40%. How much is it worth now?
$70 x (1 + .4) = $98.
Hold the smiley face and the trumpets. WTF happened here?
It is basic math: the order matters. The 30% decline was calculated on the original price of $100, whereas the 40% gain was calculated on the new price of $70. In fact, you needed a rally of about 43% to make up for a 30% loss.
Consider this table:
|Drawdown||Return needed to get back to even|
Somewhere around a 30-50% drawdown, getting back to even becomes a real problem. Once you have lost half your money, you need to double it again just to get back to even. Doubling your money is hard to do.
That is why many hedge funds that lose 50% simply close down rather than try and work back to even. That is why Buy and Hold sucks: the stock market has suffered multiple large drawdowns over time. That is why low vol. investing seems to work: not losing money in bad times is more important than making it in good times.
So how to translate this into the real world? It is one of the main reasons that I try to discipline myself to get out of losing trades quickly. I hate being in positions that are losing money. Part of it is psychological: making money is a happy experience, and I’d rather spend more time having happy experiences. But the main reasons is mathematical: it is very difficult to recover from large draw-downs in capital. You need to actively protect yourself against the Drawdown Curse.
It sounds silly, but I have a calendar alarm that goes off at 11am every trading day. It says,
If you are losing money, then stop it.
It certainly does not always work. But it helps focus the mind. Rule Number One: Don’t Lose Money.
* On a tangent, I have considered writing a blog called “Grumpy Young Man Yells At The Newspapers” because I so often get mad at what I read in the press. I am not even talking about the “political opinion disguised as news and facts” sort of thing that plagues everything from the New York Times to the Wall Street Journal. I’m talking about the financial illiteracy that seems to pervade. Two of my favorite examples are:
$25m plantation estate sells for just $11m
from the WSJ, no less.
Ireland’s richest man declared bankrupt
from the Sydney Morning Herald.
I would love to believe that the errors were deliberate, but I suspect they were not.