How Not To Lose Money

A mistake I often see is investing too much or a lump sum all at once. Many younger people are in line for an inheritance from their boomer parents once they umm….depart shall we say.

There is always a temptation to go big when you receive a bucket of money, because of course you are going to make money, right? This is why learning about money and investing is important before you start investing. 

Most of us think in positive terms - how much can I make from my windfall and this means the more you invest, the more you make.

But not so fast.

Have you thought about what happens if you choose badly and lose?

Your investment amount is $1,000.

If you buy a stock for $100 and it falls 20% the new price is now $80. You need 25% to get back to where you were if you don’t buy any more. But because you spent the lot, you now have to sit and wait for the stock to rise again back to its original $1.

But let's say you are conservative (because you realise you don't know what you are doing). So you start with buying a single stock for $100. So $900 in cash. 

But you decide to buy another single stock at $80 then you have spent $180  with an average price is of $90. To get from $80 to $90 requires a rise of 12.5% which is half of the original 25%.

If you buy 2 at $80, you have spent $260 but your average cost is now $86.60. Now you only need 8% to get back to square.

If you buy 3 at $80, you have spent $340 for 4 shares with an average cost of $85. You need a 6% return to get back to square.

The idea is if you start small (relatively) you should be ok averaging down especially for the whole market.

So if you need 25% to get back to square (from buying at $100 and the stock falling to $80) buying 3 more means you only need 6%. That is 4 times less which is good. Thus it is better to average down in larger amounts.

If you buy 9 at $80 then you total spend is $820, so you only need a 2.5% rise to recover. This feels like a lot when your original outlay was only $100 and now you outlay 7 times that amount. But look at the difference it makes in terms of reducing your potential losses and the gap between your current holding and the break even price.

This is why holding cash is important. It can limit your losses; reduce your average purchase price thereby reducing your mistakes and actually improve your returns. An additional benefit is you now have 10 shares at $82 and a small rebound will see you with a larger profit since you hold ten shares not one.

Investing this way with individual stocks is difficult because they can always go to zero and quite a few do. Some fall to $80 and don’t recover. But because they have a remote chance of going bankrupt, an index or broad sector ETFs are an excellent and simple way to invest with peace of mind.

This is why you should start small with ETFs. However the main lesson is to not run out of money and retain sufficient funds to withstand a large drawdown. If you are planning to invest for a long time - 20-30 years, then I guarantee you will experience a large drawdown at some stage. Knowing what to do at that time is the difference between average and superior returns.