The Loss Hurdle
Lord Alfred Tennyson, the great poet, said "Tis better to have loved and lost than never to have loved at all". This may have been good relationship advice but it turns out to be a lousy investment philosophy.
Investment commitments or "relationships" that lead to heartbreak can be difficult to recover from. Realizing the grueling work needed to recoup losses concentrates the mind on the front-end before a flirtatious thought leads to an impulsive decision. If you were to lose 10% of your capital, you would need to reinvest the remaining portion at 11.1% to break even. If you lost 20%, your surviving capital would need to earn 25% to recoup. Lose 35% and a 53.8% return is demanded. This endearing progression continues until the returns required just to get back to the starting block are completely indecent and increasingly unlikely.
As this scenario unfolds, a very ignoble human trait often gets stirred- irrationality. If not on guard against it, investors at this point may be tempted to accept unintelligent risk in an effort to get back what was lost. They may find attractive what would never have been appealing to them in their right minds. This thought process, although it has a different motivation, looks eerily similar to the thought process that started the problem.
There are innumerable ways to lose money, but one unacceptable way is cavalier behavior. All investments carry with them a potential for loss, but investments made indiscriminately are over-achievers in this department- they have the greatest potential for loss. A temptress that often lures bad investment behavior is escalating prices combined with very few good reasons for those prices beyond the rising prices themselves. This occurrence seems to be powerful enough to be enticing regardless of what the underlying "asset" is- at one time it was tulips. Even the highest quality investments must be said no to when prices are too high, let alone those without substance. Prices alone are skin deep.
A more covert loss is taxation. Over-activity is the enemy of the investor. Optimal investments are ones that don't need to be sold for reasonable periods of time- the longer the better. Would you rather have an investment that produced a 10% return compounded over three years or three successive investments that each produced 13% for one year? Assuming a long term capital gains rate of 20% and a short term rate for the investor of 39% (this may actually be substantially higher factoring in state and other taxes) let's look at the basic math. If this investor bought an investment that compounded at 10% and sold after three years, they would have an annual after-tax return of 8.8%. If they bought an investment that yielded 13%, sold it within a year, and were fortunate enough to reinvest the funds at the same 13% rate, doing that for three years they would have an annual after-tax return of 8.6%. A 30% better pre-tax return yet 2% lower invest-able funds. Attractive investments are sufficiently difficult to find that extra examination is warranted before the sale of one already owned.
In Lord Tennyson's defense, he probably wasn't an investor. Still, investors should have a healthy skepticism before getting into an investment relationship and might do better to learn from the country songwriter whose experience led him to pen a song titled "I liked you better before I knew you so well". It just might be more profitable to have never loved.