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The Art of Losing Money Wisely

June 2020

From February 19th to March 23rd of this year, the S&P 500 fell by roughly 34% in just over one month. Few assets, outside of U.S. Treasury bonds, were spared from the carnage. International stocks, bonds and commodities joined in the sell-off as COVID-19 swept across the globe.

While damaging to portfolio balances, we believe there are valuable investment opportunities in volatile markets for those who let logic – rather than emotion – guide their approach. As such, we focus this note on the seldom-discussed topic of how to wisely lose money.

Money-Losing Habits to Avoid

Let us examine some common mistakes which may suboptimize your portfolio’s performance. These are practices we have witnessed time and again by both do-it-yourself investors and professional wealth managers.

I Just Won’t Look – If a violent storm ravaged your home, we guess that you would quickly survey the damage (think missing shingles, broken windows and water damage) and promptly make necessary repairs to secure your home for the next storm. Common sense, right? Yet, some investors choose to not look at their portfolio during volatile market conditions under the assumption that any damage will resolve itself in due time. Market volatility affects account values whether you log in to survey the damage or not, but – trust us on this point – valuable information awaits the investor who logs into their account. For example, during a crisis, investments can move by large margins which may allow one to see how diversified a portfolio is, something that can be difficult to observe during periods of relative stability. You may notice that your portfolio is highly exposed to a market factor that you did not anticipate (like the price of oil or the level of interest rates). However, these observations can be missed – as well as the opportunity to make corresponding adjustments – by investors who wait to review their portfolios until after a recovery has begun. What a waste!

Certainly, and quite understandably, many individuals employ investment advisors to take these headaches off their hands. Sadly though, some advisors utilize a similar approach called I Just Won’t Communicate. When markets implode, many advisors have a hard time picking up the phone, sending an email, or scheduling an in-person meeting with clients. Here again, valuable learning opportunities exist for both advisors and their clients in times of market turbulence. Advisors may learn that a client’s financial situation or investment objective has changed. A client may seek to understand what went right and wrong in their portfolio. Though we cannot be sure what underlying factors contribute to a breakdown of communication in these situations, we suggest that an advisor who proactively and transparently works through these questions with a client is key to achieving a stronger investment portfolio than one who waits for – or hides from – a client call.

I’m Going to Cash Until the World Settles Down – This tactic is typically employed in one of two ways. First, one sells out of the market at the first sign of trouble, even though 10% corrections happen nearly every year. Often, the concerns driving these corrections do not turn into widespread panic and portfolios quickly recover to a higher level. This strategy inevitably leads to repeated “selling low” and “buying higher” over time, which as you can guess, may not be a great long-term approach.

Those who avoid the temptation to sell at the first sign of trouble may get coaxed into it after the market has fallen 25% and the headlines bombarding television and device screens incite panic. This strategy has a major drawback: when an investor sells holdings to go to cash, those losses are crystalized. Yet, massive market moves up may happen well in advance of “the world settling down.” For example, after bottoming on March 23rd, the S&P 500 rallied 37% to June 2nd as shown in Exhibit 1, though, we suspect few would recall the past few months as calming. After missing out on a large rally, investors may hesitate to get back in, sitting poised on the sidelines for a second dip that may or may not materialize. If the second dip does occur, conditions may have worsened to such an extent that the investor is still not comfortable reentering the market. Thus, the cycle of trying to time the market is often self-perpetuating and ultimately self-defeating. For “going to cash” to work, we believe you have to be right on your timing twice – getting out and getting back in – a task that has shown to be near impossible and relies on luck as an investment strategy.

Exhibit 1: S&P 500 Index (Trailing 1 Year)

Once Concentrated, Always Concentrated – In this case, an investor may have a well-diversified portfolio and a solid plan – except for that one stock. Maybe that one stock was a great investment made years ago, was granted by a former employer, or is the result of an inheritance. Whatever the case, while there may have been a practical time to resize the position, an emotional attachment or perhaps a tax reason, allowed that one stock to become over-weighted in a portfolio and represent a much higher risk than the investor anticipated. While this is never ideal, in normal markets with muted volatility, that one stock may perform in-line with – or perhaps outperform – other investments, making the perils of this approach seem insignificant. However, when chaos hits, the outsized position may cause substantial damage very quickly leaving little time to react. Consider, for example, some widely held bank stocks which paid hefty dividends and frequently outperformed the overall market for years – or decades – but which were effectively wiped out during the financial crisis of 2008-2009.

The Lottery Ticket – Instead of owning a well-balanced mix of high-quality assets, some investors prefer to own a smattering of lottery tickets – “high-flying” or fad stocks that go ever higher often despite a lack of earnings – spread across their portfolios. Others may own lottery tickets without realizing it – perhaps they unintentionally purchased one, or perhaps their advisor placed one in their portfolio. One problem with these holdings is that they may suffer from correlation problems. In other words, certain market environments (like the one we were just in) tend to take them all down violently at once and many do not come back up. (If a holding drops by 70%, you need a 233% snap-back to get back to even. Cruel math, we know.) We believe avoiding investments that encumber you with a permanent loss is a great secret of successful investing.

I’m Keeping My Money Safely In Cash – In contrast to the I’m Going to Cash Until the World Settles Down approach, some folks find up, down and sideways markets too stressful and have chosen to never invest, instead keeping their money “safely” in cash or bank savings accounts. Since money market, savings and checking accounts now all pay something close to zero, this (non)investment strategy can present long-term issues even for high net worth individuals as perpetually compounding inflation or lifestyle-specific inflation can gradually sneak up on folks sitting on the market sidelines. Rest assured, there are conservative investment strategies which may aid one in the fight against inflation while not exposing the investor to large drawdowns with no chance of recovery.

A variant of the “sit in cash” approach is the “hedge everything” approach. Some investment advisors design exceedingly complex portfolios using inverse ETFs, options and other alternative exposures in pursuit of a smooth, positive return over time. Unfortunately, hedging away all perceived risks to one’s portfolio may result in a low expected rate of return and a high level of fees. While we acknowledge there are circumstances where portfolio hedging may be appropriate – just as we believe there may be legitimate reasons to hold a portion of your portfolio in cash and conservative fixed income investments – long-term investors can overpay for this ongoing “protection” and sacrifice long-term returns in the process.

Exhibit 2: US FDIC Avg. Nat’l Rate for Non-Jumbo MMKT Accounts (Trailing 1 Year)

A Wiser Way to Lose Money

Now, we turn our attention to more optimal and time-tested approaches to reach your long-term investment goals.

Having Market Exposure – Markets will rise and fall, and your portfolio value will too at times; however, in a well-balanced target-allocated portfolio – that is ok, because you invested with the belief that, over time, having exposure to stocks and bonds will earn a greater return than funds sitting in cash. Keep your focus on long-term returns and the risk that it takes to achieve them.

Dollar Cost Averaging – You may sometimes lose money by dollar cost averaging into your investments. We love investing more in our favorite names during a big market downturn, but try as we might, we rarely pick the bottom to add to those investments. Such is life. Nonetheless, we are building positions for the long-term in companies we believe represent compelling investments at the prevailing prices, so we are ok with some resulting short-term pain.

The Calculus Changed – Making investments in good assets does not guarantee good returns. In such cases, there may have been a meaningful change affecting a specific stock (a key employee left the company) or the economy (a pandemic swept across the globe). Despite the careful planning and homework that goes into making an investment, the world may change in ways that affect the outlook of a stock, and you may lose money as a result. While we do not suggest making hasty portfolio adjustments on the basis of quarterly news that does not directly affect an investment thesis, as facts shift and alter the long-term view, one may need to resize or rethink an investment position. Should that require one to cut a position which has fallen in value, that is ok. Focus on optimizing results over the long-term and not about obtaining a target exit relative to an arbitrary cost basis.

No FOMO – Inevitably, there will be periods where your portfolio is not in the “hot spot” driving the market. Perhaps you did not have exposure to a sector like financial services because you were worried about a recession. Perhaps you did not own a specific niche of stocks like medical marijuana or oil services companies due to concerns about valuation. Perhaps concerns about global growth led you away from specific areas of the world like emerging markets. Regardless, it is not fun missing out on what is “hot”, but it goes with the territory.

While this is certainly not an all-encompassing list, we hope these examples help shed light on common money-losing mistakes and a more palatable approach to calculating investment risk. Regardless of whether you are a do-it-yourself manager of your investments or if you have a professional investment advisor, if you find yourself repeatedly running into habits to avoid, then you may be well-served to seek outside help. After all, optimizing the way you lose money is just as important as knowing how to make it.

The commentary is for informational purposes only and the opinions expressed herein are those solely of Hamilton Point. Hamilton Point reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. There is no assurance that any securities or strategies discussed herein will be included in or excluded from a client portfolio. It should not be assumed that any of the securities, strategies or internal studies discussed were or will prove to be profitable or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. An investment in our strategies is subject to investment risk, including but not limited to, the loss of principal and may not be suitable for all investors. This is not a recommendation to buy or sell any particular security and should not be considered financial advice. Past performance is not indicative of future results.

A full description of Hamilton Point and its investment strategies and advisory fees can be found in Hamilton Point’s Form ADV Part 2 which is available upon request or at the Investment Adviser Public Disclosure website. Hamilton Point is an investment adviser registered with the U.S. Securities and Exchange Commission, though such registration does not imply a certain level of skill or training. Hamilton Point’s principal place of business is in the State of North Carolina. HP-20-153


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