Don't lock in permanent losses | Fin24

Don't lock in permanent losses

Jun 22 2016 08:00
Anet Ahern

Reading the title of this piece, the discomfort sets in immediately. We don’t like thinking of losses, never mind permanent ones.

And we don’t need a behavioural expert to tell us that when it comes to investing, we feel the pain of losses (or even just declining markets) much more intensely than the satisfaction of positive investment returns. 

Why is it important to not lock in permanent losses?

It should by now be a well-known fact that the average investor does worse than the market. The biggest reason for this underperformance is the fact that these investors allow their emotions to get in the way of their long-term investment needs and goals, which sees them buying high and selling low.

On the one hand, the average investor tends to get overexcited and buys when markets or funds are rising (becoming more expensive) and when there is an abundance of good news.

On the other hand, the average investor panics and sells when news flow is bad and markets or funds have declined.

It’s these actions which significantly dent their chances of meeting their long-term investment objectives.

What is a permanent loss?

We see a “permanent loss” as a loss that will be very hard or impossible to make up. One way to define this is when the value of something is impaired forever, or for the length of your investment horizon, regardless of whether you have sold the investment and realised the loss or not.

An example of this would be buying a house in Ireland at the peak of the property market in 2007 – a highly inflated market – and seeing the value of equivalent properties fall by as much as 50% by 2012.

Even though you have not sold your house, it is clearly worth a lot less than when you bought it and, in the case of Ireland, this is still true nearly 10 years later.

The other way to define a permanent loss is to look at what happens when you sell a good asset in a bad situation. In other words, when the reduction in market price was temporary, and in fact a buying opportunity.

An example of this would be selling a good quality share like SAB during the 2008 market crash. The share fell by more than 35% in the space of a few months. Holders of the share would have been tempted to sell early in 2009, but would have rued their decision when the share went up seven times from its low to where an offer was pitched by Anheuser-Busch – five times up from the “peak” at which it was bought in 2008.

It would have been tough finding an alternative with the proceeds that gave the same return in the following five years!

Another example of selling a quality asset and locking in a permanent loss would have been Capitec during the time that African Bank (ABIL) was placed under curatorship in 2014. The Capitec share price fall was not all that dramatic in hindsight, only about 14%.

However, after what happened to ABIL, and the subsequent downgrade in Capitec’s debt, the instinctive trade would have been to sell. Here the point is not the loss investors would have locked in, as much as the opportunity they would have missed. The share subsequently tripled in value in less than two years from that “panic” low in a market that produced rather subdued returns.

Markets go up and down and, in the short term, there is little logic to how the market reflects news and other information. This makes it very hard to avoid taking actions that will incur a permanent loss. So how can investors prevent this?

How to prevent permanent losses

Firstly, if you are able to take a longer-term view, a lot of the short-term volatility will matter less and you will feel less inclined to act on every short-term move.

Secondly, the careful selection of your investments is the real key to preventing the locking in of a permanent loss. There are two guidelines that will go a long way towards preventing this. The first is to always buy higher quality shares.

The key assessments you have to make to determine quality are whether the company has a strong business model (look at all that this ideal entails, such as pricing, cash flow, a growing market and the like) and trustworthy, capable management (look at whether they own shares, and how they have acted for shareholders in the past).

This will bring you closer to having shares with better businesses and better management teams, who are able to respond to the environment with the shareholders’ interests at heart.

The second assessment is value. Higher quality certainly deserves a higher valuation, but the general rule here is to not overpay for any asset.

Buying an investment, be it a business, share or house, in an inflated situation seldom pays off and is a sure way to put yourself on the path towards incurring a permanent loss.

If you can harness the essentials of taking a long-term view coupled with a quality assessment and, crucially, not overpaying for the asset when you buy it, you will be much closer to avoiding the costly mistake of locking in a permanent loss.

*Anet Ahern is CEO at PSG Asset Management

loss  |  investments  |  financial planning