The Solution To Investment Losses

A reader commented on my blog, “Todd, my portfolio is mauled. I feel stuck and don’t know what to do. Any suggestions?” The simple answer is problems like this are avoided through a disciplined investment risk management strategy and the damage will be repaired only after improving your investment risk management skills. Let me explain with a little excerpt from my forthcoming book on investment risk management…

Every day you will make one of three decisions with your investments – buy, sell or hold – whether that decision is consciously made or not. What is seldom understood is that a hold is the same thing to your portfolio as a buy because it places that asset’s risk profile in your portfolio. In other words, every day you hold an investment is effectively the same thing as choosing to buy that asset because you can only have one of two positions – long or out – for any given investment. (You can theoretically be short also but that would be highly inappropriate for most reader’s skill level. The mathematics of profiting on the short side are difficult for full time professional investors not to mention normal investors so we will limit this discussion to long or out. The principles remain the same either way.)

You can really only do one of two things: accept risk or remove risk. It’s just that simple. You can buy, sell or hold with buy and hold being effectively the same thing because they both accept risk for the next day, next week, and so on.

The reason I mention this is because a lot of people hold investments because they don’t know what else to do in this difficult market environment. They fail to realize “no decision” is really a decision by default because it keeps the risk in the portfolio equivalent to buying the same security that day. They get stuck like a deer frozen in the headlights of an oncoming car. The poor animal gets immobilized by fear in the middle of the road thinking no decision is safer than a decision – meanwhile the oncoming car advances closer and closer to the inevitable slaughter. As long as fear keeps the deer from selling and getting out of the road he is unconsciously choosing to accept the risk of standing in the road.

It is the same thing for an investor. You can either accept risk or remove risk. You are either choosing to be in the road or choosing to get out of the road. Most importantly, choosing to stay in the road and accept the risk is equivalent to choosing to jump in the road in the first place. Either way you accept the risk of being in the road. There is no functional difference: the result is the same.

So do you want to accept risk or do you want to reduce risk in your portfolio? That is the decision you face today – and every day – regardless of what happened in the past. Every day is a new day. By not doing anything you are unconsciously choosing to accept whatever risk profile is already built into your portfolio.

Consider this question: would you buy the portfolio you have today if you were sitting comfortably on the sidelines in cash? What would you different? These are important questions to answer because holding your portfolio by doing nothing is essentially the same thing as buying it today. Pretty wild, eh?

Let me be clear that I am not recommending selling any more than I am recommending buying right now. The analogy above should not be interpreted as a recommendation to buy or sell investments. That is your decision to make and only you have to live with the consequences. I am just trying to help you get clear on at least one aspect of the decision process. There are times when it is very wise and safe to cross the road to get to fertile grazing grounds on the other side, and there are times when it is tantamount to suicide.

With regards to rebuilding your portfolio once you are already facing sizable losses, the logic is similar.

Your investments are already down. It doesn’t matter if you have sold the assets and technically realized the loss or not. The loss is real either way. A lot of people incorrectly believe that just because they didn’t sell their stocks or real estate yet that the loss is somehow magically transformed into something less real. That is pure emotional folly. The value is the value today and has zero relationship to the past. You must emotionally mark your portfolio to market every day. It is only worth what a willing buyer will pay for it today and that is determined by the market – end of story.

The only decision remaining is what investment strategy you will use going forward to begin rebuilding. Don’t get stuck in the past holding a bunch of deadwood old assets just because they are down and you don’t want to realize the loss. You must always be thinking in terms of what the best assets will be going forward. Think offensively because every day is new: focus on an offensive plan to rebuild.

You must prune a portfolio like you prune a tree to eliminate the gnarled, old deadwood and make room for healthy, new growth. Your portfolio is either growing or it is dying – there is no middle ground. By pruning the old clutter from the past you make room for new growth in the future.

That is how nature works, and that is how investing works.

In summary, every day you face a decision to buy, hold or sell. Every day you either accept risk or remove risk, and when you make no decision you effectively choose to buy your portfolio that day because it keeps the risk in the portfolio. All losses in a portfolio should be emotionally recognized every day whether you have actually recognized them through the sales process or not. This leaves you with the simple decision to determine your best investment strategy going forward without any emotional clutter or attachment to what has happened in the past.

Emotional clarity is essential to successfully investing for the long-term. I hope this helps you get grounded and make wise decisions to recover from your current losses.

If you have thoughts to add to this discussion please leave a comment below. How did it help you? What did I forget to include? I appreciate your comments…