A Strategy to Avoid The Pain of Losses? Don’t Be Naive
When Eagle Hospitality Trust’s (EHT) share price fell recently, I thought it is a rather good exercise to take a look at how 5 investors will experience the downside.
EHT is a real estate investment trust (REIT) who master leased their assets to their sponsors.
At various price points, it provides the investor with a dividend yield of 8% to 14%, based on their forecasted cash flow guidelines.
When the share price fell, many investors sell. There are also investors who think there is a value somewhere and are buying.
This is, after all, a business model that is not very unfamiliar to many people. It looks like it is fixable in the long term. At the same time, there is uncertainty because it feels like the current true value of the hotels are much less than what was stated in the IPO.
The Experiences of 5 Investors
Suppose we have 5 investors that tried and successfully gotten invested in EHT at different times.
All 5 investors have the same mentality:
- They think that at the price they buy, there is value. While the time period they are looking at is different, they believe that given the time frame they are looking at, the total return (dividend income received + capital appreciation) will outweigh the prices they are paying now.
- They all don’t like to lose money. The feeling of seeing their capital in the red kills them.
- If given the choice they want to protect their downside
- They all want to get in at the price where it is the lowest
So the price chart of EHT for the past 3 months plus look like this:
The price could go three ways:
Depend on the timeframe.
Which Investors Feel the Least Pain?
- Sell and buy back at a lower price
- Wait to buy at a lower price
- Take profit and then try to buy back lower (almost similar to #1)
- Buy only after a certain plunge
Behavioral wise, we are trying to minimize the pain.
So how did this work out for our investors?
The table shows our 5 investors, who sought to buy at the closest value point, where they will be able to maximize their profits, minimize their downside:
Suppose time suspended today and we take stock of the performance.
At this point, investors 1 to 4 all have unrealized losses:
- Investor 1 lost 35.4%
- Investor 2 lost 31.6%
- Investor 3 lost 29%
- Investor 4 lost 17%
Investor 5 has the best timing and managed to get out a 5.7% return.
Who was the Smart One?
Investor 3 thought he got a good deal.
Looking at the price chart, he got in at $0.655 instead of the high of $0.68.
Investor 2 would argue she got a good deal. Instead of getting it close to IPO at $0.72 she got it at $0.68.
If we were to use some hindsight bias, and we review this way, Investor 4 got the best deal out of those that currently lost money. She got in at not $0.72, not $0.68, not $0.655 but a much, much lower $0.56.
At this point, the smartest is, of course, Investor 5 who managed to end up with a profit.
In the end, the 3 investors after the first one didn’t avoid downside. They still suffered losses.
The Impact may be Different If We Consider the Potential Absolute Losses
What spook most of us with losses is that:
- We think we are making the biggest mistake of our lives
- We think we are losing a large part of our net worth and that is irrecoverable
In terms of percentage, the impact might not be as big. But what if we present it in terms of absolute dollars?
Imagine that Investor 1 to 5 invested $100,000.
Investors 1 to 3 have potential losses of nearly $30,000 while Investor 4 has potential losses of $17,000.
To some of you losing $30,000 is a very, very, very big deal and something very distressing. For some of you, this is nothing much.
What if We Layer in Net Worth and Time Horizon?
Suppose I tell you that Investor 1’s net worth is $2 million.
Do you think if you are Investor 1, you can endure an unrealized loss of $-35,417?
I think Investor 1 had an easier time than Investor 3 if we know Investor 3’s net worth is $120,000. With a $-29,000 loss, she almost lost 24% of her net worth.
But Investor 3 will feel less pain if we know that her salary is $80,000 a year and she has 20 years more to retirement.
While this potential loss is large if she can critically think, her savings from her salary over the next 20 years will more than offset this $29,000 of potential loss.
You Need to Learn to Live with Psychological Stress of Being in the Market
We all wish to avoid feeling the pain of seeing our hard earn and previous money vanish in thin air.
But if we use price as the sole indicator in our investment decision making, you might not avoid that painful feeling of seeing your portfolio in a losing position.
In this EHT example, 4 out of the 5 investors suffered the psychological stress of seeing their portfolio in a big losing position.
There is this strategy being passed around that you should only invest in a great bear market. One where the market went down at least 30%.
It is likely they wish to
- avoid losing money
- looking like a vegetable head
- suffering losses to their psychological capital
The math of things tell me that you can’t avoid the pain of seeing large unrealized losses in your portfolio.
You cannot avoid the pain:
- For those picking the bottom, only a handful would manage to do that. And they do so by luck most of the time
- For those buying at the bottom, if you see a stock go down from $1.00 to $0.30 and you buy it, don’t feel surprise seeing it go down to $0.15. You avoid a 70% potential loss, only to get into a 50% potential loss.
What is the solution?
Based on what I understand being in the markets this 15 years, there is not much strategy that can make you avoid the pain and still earn a great return.
It means… you need to increase your willingness to take risk by learning to endure this psychological stress.
Long term, you are likely to earn good returns.
The cost is that you need to pay for this by enduring psychological stress.
This is Your Pact with the Devil.
Being a historian of the markets, being a connoisseur of understand behavioral finance can help you cope with the pain of unrealized losses better. It may enable you to retain as much psychological capital as possible.
Lastly, in financial planning, we talk about your ability to take risks. Many pay lip service to it until they take psychological damage from the markets and see their psychological capital depleting at a much faster pace than their financial capital.
I have shown you that your position sizing, relative to your net worth, to your income and how far you are from your wealth accumulation goal, affects how much psychological damage that you may take.
If you are near your goal, your income is going to stop soon, your ability to take risk is much, much lower even though your willingness to take risk is high. If you lose a large part of your capital, it will be very hard to earn them back.
However, if you have a long time horizon, even though you have lost a significant part of your net worth this time around, you learn from this possible mistake. In the next 15 years, you would replenish your capital through savings and if the stock recovers.
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