How You Manage Investment Losses Will Ultimately Determine Your Profits. Learn Which Investment Strategy Makes The Most Of A Bad Situation…
My first investment was a complete loss. I know that doesn’t make for ego pleasing, cocktail party conversation, but it’s the truth.
In this article I’m going to tell you the whole story about how I lost 100% of my invested capital many years ago and the investment mistakes I made to create this disastrous result. But first I want to tell you why I’m doing it.
“The most important thing in life is not to capitalize on your gains. Any fool can do that. The really important thing is to profit from your losses. That requires intelligence; and it makes the difference between a man of sense and a fool.”
There are two points to this story:
- Losing investments can be great teachers. You will learn from every investment mistake you make, and you can also learn vicariously from other people’s investment mistakes so that you don’t have to make the same error yourself. Each investment lesson learned can help you avoid a loss in the future which can turbo boost your lifetime investment performance.
- Losses are a natural and normal result of making investment decisions, and the key to long term success is what you do when they occur. You must learn from your investment mistakes so that you don’t repeat them. You must also cut your losses once the mistakes are recognized so that they don’t grow to unmanageable proportions.
The truth is I’ve made more investment mistakes and incurred more losses in my investment career than this web site has space to share – that’s why I’m such a great teacher :-).
It is also why I’m a successful investor today.
Below is my personal story of my first investment – a total loser. Go ahead and laugh at the foolishness. We all start somewhere and this story is proof positive that I was not born a great investor. Investing is a learned skill and the lessons contained in this story can help you avoid the same mistakes I made so that you can become a more profitable investor.
One Big Investment Mistake
This story begins shortly after graduating from college when the book “In Search of Excellence” was a nationwide bestseller.
I had been hired by Hewlett-Packard, which was featured in the book, and placed on the fast track to success. My business background was extensive for a zitty-faced, college graduate, and I had aced my GMAT test scores in preparation to begin an MBA degree program at business graduate school.
In short, the future looked so bright I had to wear shades.
“Sometimes your best investments are the ones you don’t make.”
While at Hewlett-Packard I befriended someone in the credit department who knew about this “hot new tech company” that was buying HP mainframe computers to run its business. Its stock was listed in the NASDAQ pink sheets and my buddy had the inside scoop because of his job doing all the credit analysis for financing the computer purchases.
Well, being a brand new investor with zero experience or savvy, I plunged all the money I had saved for graduate school into the stock. This decision proved to be one big mistake from the beginning. Below are a few of the more obvious mistakes I made with this investment:
- Investment Mistake 1: I bought on a “hot stock tip”.
- Investment Mistake 2: I risked money I could not afford to lose.
- Investment Mistake 3: I had no buy or sell discipline – no investment strategy.
- Investment Mistake 4: I bought a story rather than business fundamentals.
- Investment Mistake 5: I had no risk management plan to control losses.
- Investment Mistake 6: I put money at risk without an exit strategy in place first.
From Profit to Loss with No Investment Strategy
At first all appeared well as the stock nearly doubled in price. The problem was I thought this growth in value was because of my superior stock picking skills – wrong! I had no clue that new issues are often supported by the offering company during the initial distribution phase to attract investor interest. I didn’t know that rising prices and hype are frequently used as tools to distribute stock to naive investors like me.
- Investment Mistake 7: Don’t play a game you don’t understand fully. I knew nothing about the new issue game and was gambling rather than investing. I had no competitive advantage and there was no mathematical expectation to my investment strategy.
“Every experience is a lesson, every loss is a gain.”
Sri Sathya Sai Baba
Soon the stock hit its all time high and I was making good money. I had visions of becoming the next Peter Lynch or Warren Buffet as I labored under delusions of my financial intelligence.
- Investment Mistake 8: Don’t confuse brains with a bull market. Even the dumbest investments can create temporary gains when the wind is at your back.
Immediately following on the heels of the all time high was a rapid descent in price that swallowed all previous price gains. I was in despair as the position went from a winner to a loser in a short time.
Magically, just as I began to worry I got a call from my broker. It seemed as though he could read my mind and knew about my worries. Duhh!! He extolled the virtues of the company and told me all the good news about “big developments soon to be announced” and how the price was “certain to make new highs and create enormous profits.”
“If you have made a mistake, cut your losses as quickly as possible.”
Bernard M. Baruch
My greed glands began working overtime as I swallowed all of the broker’s bull – hook, line and sinker. Not only did I hold my losing position in the stock, but I even added to it by buying additional shares.
(The gulping sound you hear in the background is me swallowing my pride as I write this.)
- Investment Mistake 9: Bought based on news.
- Investment Mistake 10: Let good money chase after bad: averaged down.
- Investment Mistake 11: Didn’t understand the incentives of the advisor and the biases it created in the advice given.
- Investment Mistake 12: I didn’t protect my profits, and I didn’t control my losses while they were still manageable – no risk management.
I could add even more mistakes to this list, but I think you get the point.
The punch line to this story is the stock never looked back and went straight to zero. I lost 100% of everything I invested which was most of what I had at the time. Ouch!
I never did go to graduate school. I decided to get an education investing instead, and I’ve never regretted that decision.
Investment Strategy: Profit from Your Losses
This first investment was the first of many tuition bills I paid to the school of hard knocks during my journey to investment success, and it was also one of the most painful.
What made it so painful was that I had no idea what went wrong. All I knew was that all the money I had worked for and saved for graduate school was gone, and I had made the decisions that caused it to happen. I was confused and hurting.
My question for you is: how many of the above investment mistakes are you making? How much are these mistakes costing you?
“The worst mistake investors make is taking their profits too soon, and their losses too long.”
One of the key factors to my investment success is that I try to always learn from my mistakes. I constantly improve my investment skills by studying each losing investment to understand what went wrong with my strategy, and then I set up disciplines to assure I never make the same mistake again. Over time the investment lessons learned from this process of dissecting investment losses has paid returns many times in excess of what the losses cost.
In other words, I took the pain of this financial catastrophe and used it as motivation to learn what works in the markets, what doesn’t, and why. That is knowledge you can benefit from.
I didn’t just say “oh well” and write off the loss to bad luck, tough market conditions, or faulty investment advice. I didn’t labor under the false premise that it wouldn’t happen again or the market would come back. I never deluded myself into believing more of the same investment strategy might make me a lucky million by finding the next Microsoft or IBM.
What about you? Are you using any of these excuses to dismiss your investment losses as not reflecting a fundamental flaw in your strategy?
“The willingness to accept responsibility for one’s own life is the source from which self-respect springs.”
Instead, I took responsibility for the loss. The reality is if it happened once then it could probably happen again. The only solution is to figure out what caused the problem in the first place so that it can be avoided in the future. Taking self-responsibility for your investment losses is the first step to improving your investment strategy so that you can become a consistently profitable investor.
Nobody starts out as a great investor. Proper investing is a learned skill. You now have indisputable, written proof that I began life as an investment idiot. Few people make more mistakes on their first investment than I made. You can’t do any worse than lose everything. Yet, I am a successful investor today, and it is largely because I have learned from my mistakes.
Investment Risk Management is the Key
The final mistake on the list, Investment Mistake 12, is probably the most crucial mistake to avoid. You must always invest with a risk management discipline. This is critical. Never violate this rule.
“The first step in the risk management process is to acknowledge the reality of risk. Denial is a common tactic that substitutes deliberate ignorance for thoughtful planning.”
If you make all of the other investment mistakes you might still recover over the long-term if you don’t make Mistake 12. The key to a consistently profitable investment portfolio is to control the losses for each individual investment. The way you do that is through risk management. I violated this principle by allowing the stock to go from a winner to zero.
Controlling losses in each investment lowers the risk profile of your portfolio, reduces its volatility, and can increase its return. This is not opinion but is mathematically provable. I’ve spent decades researching investment strategy and have not found an exception to this rule. That is a big statement so please read it carefully.
Controlling losses when you make an investment mistake should be your primary concern. Learning from your losses should be your secondary concern.
Four Questions So That You Can Profit From Your Losses
Below are four questions to ask yourself when an investment loses money so that you can turn a bad situation into something that creates a long-term benefit.
- What is the flaw in your investment strategy that caused the loss? (Hint: Blaming the loss on market conditions, bad investment advice, or bad luck is not acceptable because that’s not self-responsibility. You must determine what you did to cause the loss because ultimately you are at fault.)
- How are you going to limit the amount of loss so that it doesn’t become catastrophic? What is the exact mechanism and process?
- What changes are you implementing in your investment strategy so that this loss serves as a spring-board to greater, more reliable profits in the future?
- What is your basis for believing this investment strategy change is valid? What studies, research and market history can you cite as evidence showing your conclusions are factual and will lead to more consistent profits in the future?
“Cut your losses and let your profits run.”
“…life is change, and a lot of that is loss. It’s what you gain from that loss that makes life.”
The answers to these four questions could be worth a fortune to you over your lifetime. They can turn each temporary loss into a long-term profit as you improve your investment skills and knowledge with every mistake made. These questions can springboard your investment performance by focusing your attention on what works, what doesn’t, and why.
It is important that you ask these questions after every investment loss because what you do with your losses will ultimately determine your wealth. I’m living proof of that truth.