The Most Important Element in Investing

What would be your answer if you get asked the following question: “What is the most important element in investing”? For me, the answer is straightforward and can be captured in two words: Capital Preservation.

In my view, Capital Preservation is an investment strategy characterized by the desire to minimize the risks of suffering losses. Warren Buffett puts across the message best through his famous saying:

“Rule No.1: Never lose money.
Rule No.2: Never forget rule No.1”

Let’s take a look at the table below with regards to the perils of suffering losses on a portfolio-level, a process otherwise known as drawdowns.

Percentage loss of capital (drawdown) Required return to undo drawdown
10% 11.1%
20% 25%
30% 42.9%
40% 66.7%
50% 100%
60% 150%
70% 233%
80% 400%
90% 900%
100% Infinite

As you can see, drawdowns can hit really hard with the compounding effect working in the opposite direction. Let’s take an initial capital of S$1,000 as an example. If your capital is wiped off by 40% (a drawdown of 40%), you would need a 66.7% return in order to just undo the loss and get back to the starting point again. The math works as such:

  • Sum left after 40% drawdown: $1000 – $400 = $600
  • Return required to claw-back losses: ($400/$600) x 100% = 66.7%

So, the more severe the drawdown, the harder it is to go back to the original starting point. The problem is often made worse when investors plough even more capital into increasingly reckless trades in an eager bid to recoup losses, only to sink deeper into quicksand.

One way to avoid losses

Although it is impossible to completely avoid losses, when our first priority is to focus on capital preservation, we will refrain from trying to generate a return through speculative means in the stock market. For instance, we would not care much for speculative stocks that do not have strong underlying business fundamentals.

A focus on capital preservation would also see us develop the good virtues of patience and discipline so that we can invest for the long-term. Investing for the long haul – something which The Motley Fool has been espousing since Day One – is also an important part of capital preservation because of two key reasons.

Firstly, studies have shown that frequently trading in and out of stocks eats into investors’ returns. An important study on the subject, published in 2000, was done by finance professors Brad Barber and Terry Odean from the University of California. They reviewed the brokerage records of more than 66,000 households in the U.S.A. between 1991 and 1996 and found that those who traded the most underperformed the market by up to 6.5% annually.

Secondly, historical precedents have shown that the odds of losing money in the stock market – be it in the Straits Times Index (SGX: ^STI) in Singapore or the S&P 500 in the U.S.A. – have been dramatically reduced the longer we hold our shares. Here’s what my colleague Chong Ser Jing has to say regarding how time benefits a hypothetical investor who bought into the Straits Times Index:

“Measuring returns at the start of every month from 1988 to August 2013, if the index was held for a year, there’s a 41% chance of sitting on negative nominal (i.e. unadjusted for inflation) returns. Hold it for 10 years, and losses occurred only 19% of the time. Double the holding period to 20 years however – here comes the kicker – and there were no losses.”

As for the relationship between the S&P 500’s returns and its holding period, the chart below, borrowed from another of my colleague, Morgan Housel, would paint that proverbial “thousand words”:

Long-term returns for the US stock market

Billionaire investor Warren Buffett once said that “You only have to do very few things right in your life so long as you don’t do too many things wrong.” It’s certainly not wrong for investors to focus on capital preservation.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor James Yeo doesn’t own shares in any companies mentioned.