It may seem like an outrageous statement to make, but around 90% of beginner investors don’t know or understand the one thing every seasoned investor knows is the secret to making money in the market.
You see, most beginners come to the market looking to make their fortune. They pick the stocks which they believe are going to make them the most money, with little consideration going into other factors.
But this approach misses out one key factor.
The preservation of capital
Yes, you should pick the stocks which have the most potential for upside after conducting rigorous due diligence. However, you should also seek to pick the stocks which have the least downside risk. Many investors forget to include this in their analysis, instead concentrating on the upside potential without giving any regard to downside risks.
The presevation of capital is the single most important consideration for all of the world’s greatest investors and it is easy to see why. Say one of the stocks in your portfolio went sour last year, the company turned out to be a fraud, the shares were suspended, and you lost 100% of your investment. In a well diversified equally weighted portfolio of around 30 stocks, this total loss would cost you 3.3% of your capital.
Over the past five years, the FTSE All-Share has returned an average of 5.3% per annum and over the previous three years, the index has produced a return of 3.9% per annum. By using these figures, you can see how just one the significant loss can severely dent your returns over just a few years.
For example, if you invested £10,000 in a basket of 30 stocks for five years, and assume a return of 5.3% per annum, at the end the period you would have a total of £12,946 — a total return of 29.5%. However, if you took a 100% loss on a single 3.3% position during year two, by the end of the period the total value of your portfolio would be £12,577, a total return of 26% — £369 less than the portfolio that avoided the loss.
Over the past three years, the difference in returns is even starker. Assuming a return of 3.9% per annum over the past three years, a £10,000 portfolio would have turned into £11,216 by the end of the period for a total return of 11.2%.
If we assume a 3.3% loss during year two in the same portfolio, then over the three years the initial £10,000 investment will only have grown to £10,859 for a total return of just 8.6% — £357 less than the value of the portfolio without a loss.
If you model the figures out for a decade, the performance gulf grows even wider. Over ten years, the value of the second portfolio, assuming returns of 3.9% per annum with no loss, will see a total return of 46%. But the portfolio with a 3.3% loss in the second year will see compound growth of only 25% over the period.
The lesson is clear — avoiding losses is a key factor for great portfolio performance.
