Trade risk management, part 3: Risk before reward

The effect of losses on investment returns is not intuitive to understand. In the following table, we show the mathematics of losses, based on an initial investment of $100, together with the breakeven gain needed in dollars and percentages to get back to this initial investment value after the loss has occurred.

Losses based on $100 investment, with gains needed for breakeven
 

The key point is that losses are not symmetrical to gains. As losses become larger, the gains needed for breakeven become larger still. We can observe this pattern by comparing "Loss percentage" to "Breakeven percentage" in the table. This highlights the importance of a risk management process that seeks to prevent large losses from becoming huge losses. Getting to a loss of 40% needs a gain of 67% for breakeven — no easy feat. But reaching a loss of 60% needs a gain of 150% for breakeven. This erosion of value can be hard to recover.

Less dramatic losses can also be highly consequential for long-term investors. In the following table, we compare the annual returns of 2 investors, Steady Stephanie and Erratic Eric.

A tale of 2 investors

Steady Stephanie was cautious about losses. She diligently used position sizing to manage the risk of loss from any one stock and also used target prices, stops and layers to manage entries and exits with a focus on risk, as covered in our related articles. Erratic Eric was less cautious. A good stock picker, he thought a bit about risk but was never that concerned about it, based on his belief that the winners more than make up for the losers.

Steady Stephanie alternated between gains of 20% and losses of 5%, while Erratic Eric alternated between gains of 30% and losses of 20%. When we sum the 5 years of returns for each investor and divide by 5, the average or mean return is 10% in each case. It's a different story when we look at the compound return — the rate at which their investments accumulated over time. Because Stephanie had smaller losses than Eric — 5% versus 20% — her investments accumulated at a higher rate. In fact, Stephanie's compound annual return over the 5-year period was 9.29%, while Eric's was 7.05%.¹ Now let's imagine this difference held up over a longer period. In the following table, we show the compound growth of $100,000 over 10, 20 and 30 years, based on each investor's compound annual return. ²

Compound growth of $100,000 investment

Compound returns matter more than mean returns for the long-term investor. By putting risk before reward, Steady Stephanie ran a more consistent investment process than Erratic Eric. For good measure, she also ended up with a larger balance.

Risk management is important for all market conditions but is vitally important when losses start to mount

A solid risk management plan can help you handle bad events and keep going as an investor. This plan starts with your investment objectives and risk tolerance but also includes more specific ways to manage risk, such as how you size positions or manage entries and exits.

As losses become larger, the gains needed for breakeven become larger still

A disciplined investment process can’t prevent losses from happening on individual investments. But it may help to reduce the risk of losses from becoming very significant for the portfolio as a whole.

Compound returns matter more than mean returns for the long-term investor

Given 2 investors with the same average or mean return over the same time horizon, the investor with smaller losses will realize a higher compound return. This can make a substantial difference to wealth accumulation over the long term.