The Strategic Investor: Part I, Learning to Love the Loss

What was the most memorable line of the original Karate Kid movie? Probably, “wax on wax off.” Remember that? This was the part where Mr. Miyagi had Daniel painting his fence and sanding his deck and waxing his cars:

Miyagi: [Miyagi returns from fishing as Daniel is painting the house] Oh, miss spot.
Daniel: What spot? Hey, how come you didn’t tell me you were goin’ fishing?
Miyagi: You not here when I go.
Daniel: Well, maybe I wanted to go, you ever think of that?
Miyagi: You karate training.
Daniel: I’m WHAT? I’m bein’ your goddamn SLAVE is what I’m bein’ here man, now c’mon we made a deal here!
Miyagi: So?
Daniel: SO? So, you’re supposed to teach and I’m supposed to learn! For 4 days I’ve been bustin’ my ass, and haven’t learned a goddamn thing!
Miyagi: You learn plenty.
Daniel: I learn plenty, yeah, I learned how to sand your decks maybe. I washed your car, paint your house, paint your fence. I learn plenty!
Miyagi: Ah, not everything is as simple as…
Daniel: Oh, bull****! I’m goin’ home, man!
[Daniel turns to walk away] Miyagi: Daniel-san! Daniel-san!
Daniel: What?
Miyagi: Come here.

Daniel was learning via an indirect route, which is sometimes the most effective way to accomplish something. The wax on wax off motion that he just did 500 times? It turns out that can also be used to block a punch. He was learning karate by doing something else.

A football team that continues to run the ball up the middle for no gain, time after time, can appear to be stubborn and futile. The true aim of those plays is revealed later when a defender bites on a fake handoff and allows a receiver to get behind him for a long pass reception. Run the ball to pass the ball.

A timid early playing strategy can ultimately reward a poker player by building “fold equity.” A bluff is most effective when you’re not seen as a bluffer. Starting out conservatively can allow you to be more convincingly aggressive later. Be weak to be strong.

In 1935, the Forest Service’s fire management policy stipulated that all wildfires were to be suppressed by 10 A.M. the morning after they were first spotted. On the surface, the direct route to fire suppression appeared successful. Before this policy, wildfires burned about 30,000,000 acres of forest land in an average year. By the 1960’s it was less than 5,000,000 acres/year.

By the late 60’s, foresters recognized that this unnatural suppression of fire had allowed dangerous amounts of underbrush and dead trees to accumulate. The National Park Service changed policy to allow most naturally occurring fires to burn themselves out and they even conducted some controlled burns. These efforts were correct, but too late. In 1988, a perfect storm of accumulated fuel, drought, wind and lightning resulted in a series of fires that consumed almost 800,000 acres of Yellowstone. More than a third of the park went up in flames.

Before 1988, the largest fire ever recorded in Yellowstone had been 18,000 acres. It turns out that the key to preventing forest fires is to not prevent forest fires. An indirect solution.

Most of us are like Daniel, we’re impatient.

We wish the coach would stop trying to run the ball. When a long pass goes for a touchdown it’s obvious proof that he shouldn’t have wasted all that time trying to run.

We’ve folded four hands in a row, we should just play this Q-7. Maybe we’ll get lucky.

Why would we let good timber burn when we could just get a crew to put the fire out?

We have a hunger for immediate results and direct action. This impulse can be exploited by smart investors that have learned how to identify and use it to their favor.

Direct/Linear Approach Indirect/Strategic Approach
eager to take gains quickly before they get away lets winners run at the risk of getting away
doesn't worry about a decline if still likes the idea eager to take losses quickly
aims for high percentage of winners aims for asymmetry between size of wins vs losses
tries to predict the market and get ahead of it waits for high-probability situations
big positions/leverage to make wins decisive doesn't risk one position being decisive

The indirect/strategic investor has to learn to love losses. At first blush this might sound ridiculous, but there are some big advantages to thinking this way.

The main advantage of taking losses early and small is that it preserves capital. We won’t be right all the time and we also won’t be wrong all the time. When acknowledgment of a loss is refused, when we try to rationalize it or wish it away or claim that a “paper loss isn’t a real loss,” we allow one trade to become potentially decisive. I have seen single losses wipe out years of gains in unleveraged portfolios. In a leveraged portfolio, a single uncontrolled loss can end the game permanently. Decisively. By admitting fallibility and keeping losses manageable, we preserve capital and are better able to take advantage of the inevitable big win when it comes along. Losing allows our wins to be larger and more meaningful.

Taking losses when they’re small not only preserves capital, it unlocks it. Investment capital is a finite resource that needs to be used efficiently. If you only had access to five gallons of water per day you wouldn’t host many water balloon fights. If you only had ten minutes per day of internet bandwidth, you wouldn’t waste it on cat videos. Okay, some of you would. The loss that languishes not only costs money, it costs opportunity. Losing gets us in front of more opportunities to win.

Taking losses early and small also unlocks another finite, precious resource. Time. A few months ago I created this chart (click to enlarge) for What Is The Opposite Of Fragile?:

dd-chartThe image shows the state of recovery over the last five years for a diverse selection of equity markets. As stated in the article, “Of the fourteen markets that suffered a drawdown greater than 70%, thirteen are still underwater. On average, this group of fourteen is still 40% below where they stood before the collapse of 2008.” Refusing to take a loss early has cost holders of these securities more than five years (and counting) of futility. The strategic investor doesn’t expect constant profits, but spending the better part of a decade just trying to climb out of a hole is a killer. We don’t get that many decades as an investor. Losing can unlock years of opportunity.

The discipline of taking losses makes you a better thinker. When we make a decision that goes against us, it’s perfectly natural to look for reasons why we’re only temporarily wrong. Not even wrong really, just a little early. That’s what we do. We seek out information that confirms our opinion and we argue against or ignore conflicting information. This is known as “talking your position.” Unfortunately, these little pep talks we give ourselves don’t have any effect on the market. The discipline of taking losses helps preserve your ability to reason objectively.

The indirect route is very difficult from a psychological standpoint. Most people underestimate how hard it is to consistently think and act differently from the rest of the herd. A strategy that is purposely designed to pay off in a roundabout fashion can offer tremendous advantages, but its execution demands strict discipline and patience. It also requires an understanding that not every play has to go for a touchdown to win the game.

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Disclaimer: Past performance is not indicative of future returns. Information displayed is taken from sources believed to be reliable but cannot be guaranteed. All indices are unmanaged and investors cannot invest directly into an index. Ideas and opinions expressed in this article are the sole responsibility of Patrick Crook/PLC Asset Management and do not reflect any stated opinions of Commonwealth Financial Network, National Financial Services LLC or any other person or entity.

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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.