Tuesday, 24 Oct 2017

Diversify your investment portfolio to be able to deal with losses

201715May

Not all financial decisions turn out to be right. We must deal with stock picks that go bad; a bond that is threatening to default; or a deposit in a friendly finance company that is likely gone bust. It is not easy to deal with regret.

We wish we had an undo button to reverse that bad decision. Short of that miracle, what can we do when faced with financial losses?

There are two sets of reactions to consider: the negative and the positive. It is quite common to feel anger and aggression. Some respond with suppression and denial. Some project their failures on to others to feel better. These are negative reactions. The highly recommended positive response is to introspect, learn from the mistakes and take corrective action. It also helps to get a bit intellectual and philosophical: If it did not kill you, it surely made you stronger.

The most common situation is one where a specific financial decision has gone wrong. A stock bought with the hope of appreciation is losing money; an IPO that was expected to be a multi-bagger has listed at a discount and is going south; a fund bought with the promise of gain has fallen much below the purchase price. A frequently committed error is to hope to recover the loss from the stock or fund itself.

Behavioural scientists have pointed out that investors find it very difficult to sell what they bought at a loss, as it feeds into the regret of having made a wrong decision. It is not uncommon for investors to wait to recover at least their purchase price, or hold on with the hope that the stock would somehow recover. The only sensible approach to dealing with an investment loss is to cut it and move on. Loss from one position can be recovered with the gain from another, if we are able to release the money stuck in a losing position.

The prudent question to ask is: Would we buy this stock or fund at the current price, given the current information? If the answer to that question is no, we know that our decision was wrong. It is better to acknowledge the error and act. It always helps to ask why the decision went wrong and what we would do differently in the future.

That analysis and reflection is critical to preventing future losses. If trading in stocks and futures has become an addiction that is the issue to address. If investing in a deposit of an unknown finance company led to a loss, it is important to keep in mind the need to check the credentials of the borrower before parking money. If the temptation was to participate in a rally in equity markets, where everyone seems to be making a gain, except that it all ended after you put your money in, the lesson is that trying to time the markets does not pay.

It is also important to pin down points for action. Did you take on too much risk? Did you trust the wrong person while making the decision? Did you know too little? Did you miss something that is now obvious? Did you fail to ask the right questions? Did you decide in haste, anxious about missing an opportunity? Or were you plain unlucky?

Being able to answer these questions honestly will provide the cues to making future decisions. A retired banker friend of mine invested a sizeable portion of his VRS proceeds in the stocks of the bank he had just quit. He told me the bank stock was a good pick, but he never had enough money to buy it. The stock fell after he bought. He averaged down by buying more.

In two years’ time, we had to treat him for depression since he had lost too much money in a bet he refused to acknowledge as bad. He told me that he wanted to show his wife that he is also a rich man, by making money on the stock markets. My friend’s is a textbook case of investing mistakes and inability to manage losses.

First, he was not well diversified. Investing too much into one thing is a bet that is too risky.

Second, he did not know what he was risking and substituted his bravado for actual analysis.

Third, his action after the loss did not reduce it, but aggravated it.

Fourth, by projecting his decisions to his wife, he was trying a negative psychological coping, which is unhelpful especially since his current condition requires that his wife takes care of him.

Extreme losses that lead to financial injury require outside help. Debt counselling is now available as a professional and discreet service for people who have run up huge debts and find it tough to get out of it. Seeking a financial adviser to build long-term wealth is a good strategy to ensure that someone guides and stays with you through the ups and downs of your investment journey.

A good adviser is tested when your investment loses money. It is important to build for possible losses. Especially if it pertains to investments. It is not possible to always get a stock, bond, fund or an investment correct. There is always the risk of the unknown future when it comes to investing in the financial markets. While making investment decisions, it is important to face the question of possible losses upfront.

A diversified portfolio is the best insurance against severe losses. Individual components are less important than the overall portfolio. That is what you manage, not the unrealistic goal of having each and everything right. Diversification is easily the most underrated strategy in investing. Learn to look at your portfolio and build it for your needs. Define both the expected return and the drawdown well in advance.

If you need a 10% per annum return for your goal, your portfolio of say 60% equity and 40% debt will not deliver this number each month or even each year. In a good year when equity is doing well, return would be high. In a bad year, the return would drop below the watermark of 10%. Define how much of a drop you can take and build for that tolerance. Tweak your equity component and the amount you will invest to ensure that your return requirement and risk tolerance are in sync. Without this formal approach to managing risks, you might fall short of perspective and appropriate action when a loss hits you 

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