Q&A: What would you consider a good investment outcome?

At what percentage would you consider the investment a successful one and begin to look for an exit point? I am aware this hinges on a lot of variables but let’s just make an approximation.

When making an investment, I am looking for one of four possible outcomes:

• A small loss
• A small gain
• A medium gain
• A large gain

A successful outcome would be one of these results. To understand why these can all be considered successful, let’s turn your question around – what is a bad investment outcome?

Bad outcome #1 – A Large Loss

The surest way to cripple an investment portfolio is by suffering large losses. As I touched on in Becoming Antifragile, there is a clear relationship between the severity of a decline and your chances of recovering from that decline. As damages mount, your chances begin to collapse at an accelerating rate. The easiest way to avoid this fate is by avoiding large losses. The easiest way to avoid a large loss is to take a small loss. Think of it like a football game. To win you have to score points, but you also have to prevent the other team from scoring more than you. You have to play both offense and defense. Preventing large losses by taking small losses is how we play defense.

Bad outcome #2 – An Artificially Limited Gain

Your question implies that there should be an amount of gain that would be deemed as sufficient which would then trigger an exit. This approach is a big, but common, mistake. One of the keys to producing strong gains over time is to foster a lopsided relationship between the size of gains relative to the size of losses.

The really valuable, impactful gains are those occasional outliers – the unusually large gainers that don’t come along every day. They are much less common than the average result but can have a dramatic impact on the total return of your portfolio. If you always sell your winners at a predetermined level of gain you preclude the possibility of ever capitalizing on the vital Big Win. Since they don’t come along that often and are never obvious in advance, the risk of capping your gains early actually presents more danger than that of taking an inconsequential loss.

Bad outcome #3 – The Unplanned Exit

Investing success is largely a result of the disciplined execution of a plan. An investment plan is really just a set of rules that governs when to move money in or out of various assets. If you do not have a rule that governs an exit, you don’t have a plan. If you have a rule but you bend it depending on a feeling or a news article or something you heard from someone, it wasn’t really a rule and you don’t really have a plan.

If you don’t have a plan with rules that are followed, you’ll never be able to judge your results reliably. If you have a hunch that works out like you thought it would, was that luck or some kind of innate skill? Are your hunches reliable? Do you have a method for judging hunches you didn’t have?

To have confidence that your results are reliable and repeatable you have to have a well-crafted plan that is actually followed. Unplanned exits don’t tell you anything about your methods and make it impossible to accurately refine and improve your approach over time.

A Map for Good Outcomes

If the three factors above result in bad outcomes, a reasonable approach for achieving good outcomes would be to do the opposite:

1) Plan exits ahead of time and follow the plan.
2) Never plan to limit your gains.
3) Don’t suffer large losses.

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About Patrick Crook

Pat Crook is a financial advisor in Corvallis, Oregon with over twenty years of experience. He has developed a specialized form of investment portfolio management designed to address the risk concerns of those in or near retirement as well as organizations like charitable endowments and foundations. To learn more or set an appointment, he can be reached at 541.753.1808.