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Get Poor in a Hurry

By Morgan Housel – Aug 28, 2015 at 10:54AM

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Avoid locking in losses, and you'll do just fine.

The secret to investing is the willingness to put up with pain. Avoid the destruction of throwing in the towel when the market plunges, and you've figured out most of this game. Warren Buffett said "be greedy when others are fearful," but you really don't need to be. Keep your head on straight when others are fearful – like last week -- and you'll do fine. If you can put up with a ceaseless amount of nonsense in the short run, the long run will take care of itself.

So I shook my head when USA TODAY, one of the most circulated newspapers in America, wrote this on Tuesday:

If you own an individual stock that falls 10% or more from what you paid, you sell. Period. You don't rationalize the loss and wait for the "good stock" to "come back." Investors who dabble with individual stocks understand that getting back to even following a loss greater than 10% is a difficult task.

Whoa, timeout.

The article says the 10% rule only applies to individual stocks. "If you're a long-term investor with a diversified portfolio," it says, "academic studies have shown it's much better to ride out the volatility."

But I still can't think of any justification for the 10% rule, especially for individual investors.

Leave aside computer trading glitches, which can push shares down by dozens of percentage points for a few minutes before rebounding -- a reality that by itself makes the 10% rule a highway to regretful decisions.

I couldn't find any data backing up the 10% rule. So, I researched it.

The Russell 3000 is an index of the largest 3,000 companies in America. It makes up 98% of the stocks you can buy on the public market.

What percentage of stocks in the index have suffered at least one 10% decline in the last 10 years? Ninety-seven percent, according to data from S&P Capital IQ. So, just about all of them. In a long enough period, there are no stocks that avoid 10% declines. It's a normal part of what stocks do.

The article states that the 10% rule applies to shares falling 10% below your own purchase price, not just the market falling 10% from a high. But this isn't comforting. I crunched the numbers for the S&P 500 going back to 1957. On 29.8% of days since then, you would have been 10% or more below your purchase price at some point in the next year. That rises to 44% of all days if we look at the subsequent three years.

It's far worse if you look at some popular individual stocks. Google (GOOG -0.05%) stock is up 1,200% since it went public in 2004. But shares were 10% or more below your purchase price at some point a year later on 43% of all days during that period. Apple (AAPL -0.86%) is up 1,600% in the last decade. But on 44% of days since then, you were 10% or more below your purchase price within a year. Amazon (AMZN 0.59%) is up 26,000% since it went public in 1997. But 58% of days since then left you down 10% or more within a year.

The 10% rule is, in short, a surefire way to lock in losses and forgo long-term returns.

The heart of the 10% rule is the idea is that a stock that falls 10% has to climb more than 11% to make it back to par. The article wrote: "Investors who dabble with individual stocks understand that getting back to even following a loss greater than 10% is a difficult task."

But it's really not. Huge rallies tend to follow huge busts. The bigger the bust, the bigger the subsequent rally. That's the whole history of stock markets.

The median stock in the Russell 3000 fell 39% in 2008, which is awful. It would need to rise more than 60% from there just to get back to even. Thank God, that's exactly what happened over the next three years, with a median return of 67.8%.

History repeats this show over and over again. Stocks lost 89% of their value from 1929 to 1933. They needed to rise eightfold from then just to get back to even. Which is exactly what they did from 1933 to 1937, when you factor in inflation and dividends, according to data from Robert Shiller. Big bust, bigger rally.

Now, here's the point where I play devil's advocate with myself, and then send the devil back to hell.

According to data from J.P. Morgan, between 1980 and 2014, 40% of companies in the S&P 500 suffered a "catastrophic loss," meaning they lost 70% or more of their value and never recovered.

But the S&P 500 went up fiftyfold over that period, including dividends. 

How? Because 7% of the index's components went up tenfold or (much) more.

In all financial markets, a small percentage of companies will make up a large portion of overall returns. That's how you can earn high returns even when half the stocks in an index permanently lose most of their value.

I could see the logic in the 10% rule if your entire portfolio is made up of just a few stocks. Then you need to cut losses early lest one or two catastrophic losses destroys your whole portfolio.

But the takeaway from that isn't that you should use the 10% rule. It's that you should own more than just a few stocks. The 10% rule is like a guide on how to heal the wounds you get when you punch yourself in your face when the appropriate advice is to just not punch yourself in the face to begin with. 

There are two iron rules of investing which make the 10% rule irrelevant: 

  • You're not smarter than diversification is powerful.
  • The more you trade, the worse you'll do.

Successful investing isn't difficult. Own a diversified portfolio of stocks. Realize that the stock market is volatile. Have a long-term perspective. Period. 

For more: 

 

Morgan Housel has no position in any stocks mentioned. The Motley Fool owns and recommends Amazon.com, Apple, and Google (C shares), and has a disclosure policy.

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