Why Being a Loser Stinks

Psychologists have shown that people hate losing money -- even more than they like making money. You'd probably be happy if I came up to you on the street and handed you $100. But that emotion would be relatively small compared with the pain you'd feel if you discovered that someone stole $100 from your wallet. Now, that might not seem logical. In both cases, it's a difference of $100, so your net worth is changing by the same amount. But that loss just hurts more.

That's a great reason why you should try really hard not to lose money in the stock market. But there's actually an even better reason, and that comes from basic mathematics.

The stars are blind
Suppose your astrologist tells you that tech stocks are going to outperform in 2005, and as a result, you decide to put your entire portfolio in these four stocks.

Unfortunately, the astrologer missed that the moon was in the seventh house and Jupiter aligned with Mars, so the returns are unspectacular. At this point, you fire your astrologist and start managing your portfolio, actually focusing on the performance of the companies you own. For 2006, you buy four more stocks:

Now, this is a great result! You had a 50% loss, now you have a nearly 50% return, so you've undone the damage to your portfolio, right?

The awful truth
No, actually, you're still far behind. If you put $4,000 into the stocks in 2005, you'd have $2,000 left by the beginning of 2006. The 50% return you got in 2006 would only bring you back to $3,000, not the original $4,000 -- so you'd still have lost 25%.

To make up for your 50% loss, you need to have a colossal 100% return. In fact, any time you lose a certain percentage of your portfolio, you require percentage returns greater than the percentage loss simply to break even!

And really, breaking even isn't good enough -- you're in the game to make money, remember? As Philip Durell, the advisor/analyst for our Inside Value newsletter, noted in January's issue, capital losses "create higher and higher hurdles for future performance to reach long-term gains."

Philip's solution to this problem is to focus on not simply beating the market but on consistently achieving positive returns. This idea may seem obvious, but to lots of people, it isn't. Many institutional investors think they did well if they only lost 12% when the market's down 15%. And if you're playing a game with someone else's money, losing less than the market might be OK. But if you actually want to spend the money you make from your investments, negative returns just aren't very useful.

The Foolish bottom line
Our solution is to use strategies borrowed from master investors such as Warren Buffett and Ben Graham to identify stocks that are far more likely to go up than down. We try incredibly hard not to lose money, not just because we like our money but also because we think it's the right way to achieve extraordinary returns in the stock market. If you're interested in seeing Inside Value's top stock ideas, you can get a free pass here.

Fool contributor Richard Gibbons is just waiting for peace to drive the planets and love to steer the stars. He owns shares of Rent-A-Center. Rent-A-Center is an Inside Value recommendation. Disney is a Stock Advisor pick, and AT&T is a former Stock Advisor pick. The Motley Fool has a disclosure policy.