Winning In Investing By Not Losing

In a world that celebrates winners, it is hard to conceive that not losing can be a route to success.

Yes, winning is everything in many parts of our lives, from education to sports to work. In fact, for just about every sport, be it football, basketball or others, no one can ever remember the runner-up.

So, how is that different with investing?

In the investing world, one word is used excessively used by investment managers. The word is “alpha”.

Alpha is the amount of performance that exceeds an index’s performance. For example, a 5% alpha over the Straits Times Index (SGX: ^STI) means that the money manager performance is 11% when the average STI return is 6%.

Most money managers claim that they can generate “alpha”. Yet, research shows that a majority of funds fails to beat an index’s return. Most of them are aggressively pursuing winners, and yet end up worse.

So if the professionals can’t even beat the market, what chance do we have?

There are many reasons why we might underperform. These include over-trading, investing in losers (wrong company) amongst others. In this article, we will look at the cost of investing in a loser.

Consider the following math:

You have $1,000. You invest successfully for 9 years in various companies, sequentially, with reasonable success in your pursuit of “alpha”. You achieve an annual compound return of 20%.

However, a sudden and unexpected loss of 50% in year 10 could leave you with just $2,580, which, it has to be said, is still a reasonable performance.

Alternatively, if you had invested for 10 years in one company at a steady annual compound return of 10%, you could have ended up with about $2,594.

Mathematically, there is little to choose between the two. But sometimes, chasing alpha for the sake of alpha may not be the best route to take.

So what can we learn from this?

To beat the market over the long term, investors could try some or all of the following:

  1. Invest in well-established companies at a reasonable price (using valuation metrics)
  2. Avoid making risky investments in less-well understood companies (avoid big losers)
  3. Apply a strategy consistently

So, the next time someone claims to be able to generate “alpha”, be cautious because only a minority can do it successfully.

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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 Lawrence Nga doesn’t own shares in any companies mentioned.