The best way to absorb a loss painlessly is to try and avoid it in the first place.
The legendary investor Warren Buffett opined the following two rules of investing:
Rule one: Never lose money. Rule two: Never forget rule one
The tactical objective of absorbing losses painlessly is part of the strategic objective of capital preservation. What follows is an explanation of systematic investment process that if followed, will allow an investor to preserve capital and absorb a loss painlessly under circumstances where this loss has been mitigated thoroughly. This process can be understood as risk management. Risk management begins from the moment the investment is considered; and runs all the way through the analysis and execution phases, until either a profit or loss is realized.
To absorb a loss painlessly, one must first be in a position in which rational precautions have been taken to avoid it. There is no substitute for extensive research and analysis on the subject the risk is going to be taken in. As Frederick the Great opined, “it is acceptable to be defeated but never to be surprised.” A painless loss can be understood as one in which various loss-making scenarios have been identified and quantified, and in advance of the risk being taken. If and when the probable loss-making scenario event becomes a reality, it can then be accepted and taken painlessly.
Trigger signals can be set up in advance of the loss being taken by creating a process of early warning analysis. The news horizon should be scanned for information on the subject matter relating to the investment. This information should be monitored regularly, at least daily, to look out for early warning signals; which prepare for the loss making event becoming a loss taking action. Losses that come as surprises are always the most damaging; because they make an investor doubt their ability and their investment process.
The trigger system can be refined, by linking the loss making scenario to a quantified loss limit. The trigger is pulled when the loss making information is identified as a trigger signal. The conversion of this trigger signal into the taking of the loss can be set at a quantifiable amount of money; set in advance by the investor. The investor then has a qualitative and a quantitative control in place. The qualitative control is subjective; and depends upon the investor’s perception of the impact of the information in the trigger signal.
The quantitative control is objective; and depends upon the investor’s tolerance for financial losses. This quantitative process is known as the setting of position limits. The process can be finely tuned, to match the investor’s needs and budget. For example, a very risk-averse investor will set a trigger that is pulled immediately the news headline crosses the tape, and creates a financial loss in the position. With experience, investors will become intuitively familiar with the process, and set trigger levels appropriately for themselves. Investors with less experience should set the quantitative control at a low level of financial loss, and allow this to take precedence over the subjective qualitative control.
The science of behavioral finance suggests that investors have an inflated sense of their own abilities. As a consequence, excessive risks are taken, and rationalized by the human psyche. To overcome this innate human cognitive bias, objective financial constraints must be put upon the investor. These must be adhered to rather than mendaciously avoided.
Having done research, analysis and set up the early warning signal process, the investor is almost ready to initiate a position. In order to avoid a painful loss being absorbed before the investment thesis which was developed in the research and analysis phase has had time to work, the investor must set an optimal position size. This is something more than just saying “how much am I willing to lose”. An understanding of the background volatility in the price of the investment must be understood.
An investment with a high volatility of price movement, on a daily basis, has a high risk attached to it. This means that the investor may be forced out of his position; because it hits the trigger levels for taking the loss simply because of the daily fluctuations in its price, rather than because of any specific market moving event. Investments with high volatility should therefore be made with a smaller investment size and a higher loss taking trigger, than investments that have low volatility.
For investors who do not come from a strong statistical background, and who do not understand the statistical meaning of volatility that the professionals use there is a simple way of understanding it. Professionals quantify volatility as the square root of the standard deviation of the asset from its mean price over a period of time. Someone who does not understand this explanation should simply look back at the price chart of the investment over time; then look at the average daily range in price.
The average daily range will give the investor an indication of the daily profit and loss that will be associated with the position. A position size that fits the investor’s profile and budget will then be set by this daily price variation. As an example, a risk-averse investor will take a small position size in an investment that has a wide daily variation in price.
Having set the entry position size, the investor must set the market entry level. The market entry level must be set in relation to the underlying position size; and hence the volatility of the underlying investment. Investors will no doubt be familiar with the mantra that opines to “buy on dips.”
An investor must identify an entry point that is initiated when the investment is undergoing a correction to the underlying trend. Buying on dips creates what Benjamin Graham termed the “margin of safety”. Painful losses are therefore mitigated somewhat by this entry process. The extreme example of the “buy on dips” philosophy is the “Buy when there is blood in the streets” axiom; used by contrarian investors like Nathan Mayer Rothschild. This extreme form is known as contrarian investing, and brings with it the highest degree of risk and return. If the risk profile and budget of the investor qualify him to be a contrarian investor, then this strategy may be considered.
Once the investor has entered the position, the early warning system and trigger signals must be maintained as the news horizon is scanned over the duration of the investment holding period. News is screened against the commensurate price action of the investment. It does this using the process and framework developed above to provide a trigger signal that may allow the investor to absorb a loss painlessly. In the event that the loss is taken, it will have been fully understood and accepted so that is does not come as a painful surprise that harms the investor financially and psychologically going forward.