Why Investors Should Avoid Large Losses
The Law of Large Losses Explained
When it comes to investing, one of the most important rules is simple: avoid large losses. The reason isn’t just psychological—it's mathematical. The image above, titled "Law of Large Losses," visually demonstrates why letting losses get out of hand can be devastating for your portfolio.
The Asymmetry of Losses and Gains
At first glance, it might seem that if your portfolio drops by 10%, you just need a 10% gain to get back to where you started. But as the chart clearly shows, that's not the case. Losses and gains are not symmetrical.
- A 10% loss requires an 11% gain to break even.
- A 20% loss requires a 25% gain to recover.
- A 50% loss? You need a 100% gain just to get back to even.
- A 60% loss? Now you need a staggering 150% gain to break even.
This happens because after a loss, you’re working with a smaller base. For example, if you start with $100 and lose 50%, you’re left with $50. To get back to $100, you need to double your money—a 100% gain.
Why Large Losses Are So Dangerous
The chart’s red lines (left) show the initial percentage lost, while the green lines (right) show the much larger percentage gain needed to recover. The further you fall, the steeper the climb back. This mathematical reality is why professional investors are so focused on risk management and why the best portfolios often have fewer dramatic drawdowns.
The Psychological Trap
Large losses can also lead to emotional decision-making. Investors who see their portfolios drop by 40%, 50%, or more may panic, sell at the worst possible moment, or take excessive risks trying to recover. This can compound losses and make recovery even harder.
How to Protect Yourself
- Set Stop-Losses: Predetermine the maximum loss you’re willing to accept on any investment.
- Diversify: Spread your investments across different assets to reduce the risk of a catastrophic loss in any one area.
- Have a Plan: Stick to a disciplined investment strategy and avoid making impulsive decisions during market downturns.
- Focus on Risk Management: Remember, avoiding large losses is often more important than chasing big gains.
Summing it up
The "Law of Large Losses" is a fundamental principle every investor should understand. As the chart illustrates, the bigger the loss, the harder it is to recover. Protecting your capital by avoiding large losses is the key to long-term investment success. Don’t let a big setback put you in a hole that’s nearly impossible to climb out of—manage your risk and invest wisely!
Note: not financial advice.
Enjoy and be safe.