Honey, I shrunk the portfolio!
- Fri 10 January 2025
How to deal with inevitable, occasional losses on an investment journey.
Key points
- This article outlines four strategies to potentially minimise losses.
- They include an understanding of one’s investment ‘self’, matching investments with goals, diversification and portfolio rebalancing.
- No strategy can fully eliminate the risk of investment loss (without a cost). Ideas in this article are about mitigating some risks through well-established investing principles.
Investors come in all shapes and sizes, each with different goals, experiences and risk tolerances. But amid the diversity, they all share a common trait: No one enjoys losing money.
There is solution to potentially avoid losses on investments, and that’s sticking to low-risk assets. This approach, however, isn’t entirely risk-free.
Cash, for example, is very good at holding its value in the short term, but very bad at increasing in value over the long term.
Growth assets, such as some shares, can be bad at holding their value in the short term, while performing better over the long term.
In InvestSMART’s view, shares are a valuable component of a long-term growth portfolio. The downside is that share values – and by extension, portfolios that include shares – do not tend to grow in a linear fashion.
This is illustrated in Table 1 below, which shows that Australians shares have delivered positive returns for 29 of the past 38 calendar years [1].
In some years, the results were spectacular, notably 1993 when the market delivered a return of 40.45% [2].
Table 1: Summary of yearly changes in Australian shares over the last 38 years
Years with positive returns | 29 | Years with negative returns | 9 |
Years with returns greater than 5% | 26 | Years with losses greater than 5% | 5 |
Years with returns greater than 10% | 23 | Years with losses greater than 10% | 3 |
Years with returns greater than 20% | 8 | Years with losses greater than 20% | 1 |
Years with returns greater than 40% | 1 | Years of losses greater than 40% | 1 |
Source: ASX All Ordinaries Accumulation Index. 4 January 1988 - 5 November 2024
While investors usually find the sharemarket upswings easy to ride, the downswings are not so palatable. Fortunately, they haven't occurred as often. Even so, Table 1 above confirms that nine of the past 38 years saw Australian shares end the year in the red.
A market downturn may see investors retreat to the safety of cash and stay there. This may be the result of ‘loss aversion’, a cognitive bias that sees the pain of losing money outweigh the pleasure of making a profit.
While this response may be innate, it can potentially be costly. A 2016 study by Boston-based consulting firm DALBAR found that over the preceding 20 years, the US sharemarket delivered annual gains averaging 8.19% [3]. Individual investors earned far less, notching up returns averaging 4.67% annually [4].
DALBAR concluded that recovering just a portion of this shortfall would mean ‘hundreds of billions of dollars earned by investors’ [5]. The sting in the tail is that the study found investors’ own behaviour was ‘the chief cause of diminished returns’ [6].
In InvestSMART’s view, investors often pile into equities when the market is performing well (and prices are expensive), and exit at the first whiff of a downturn (when values are falling). This approach may lead to low returns or losses.
Strategies to potentially minimise losses
For investors, the solution is not to avoid the risk of losing money but rather to manage this risk. This is particularly pertinent as we head into 2025.
A new administration in the United States, a federal election in Australia, ongoing war and conflict in various global hotspots, all point to the potential for increased volatility.
A variety of loss-mitigation strategies are available to investors. Here are four that InvestSMART believes are worth considering:
1. Know yourself
Success as an investor does not hinge on a strong technical understanding of asset markets. Research shows that an individual's emotional ability to accept possible losses plays a key role when it comes to achieving investment objectives [7]. This makes understanding yourself a critical first step.
Know how you would cope if the value of your portfolio dipped by 10%, possibly more, in a single day. This calls for some serious self-reflection, but it can form the basis of the portfolio that is right for you, your financial goals and your risk tolerance.
2. Match investments with goals
Instead of taking an ad hoc approach to investment selection, set some personal goals. Then match your asset allocations to those goals.
As a simple rule of thumb, short-term goals potentially call for money to be held in cash and fixed income. Longer-term goals could have more weighting towards Australian shares, international shares, property and infrastructure because investors have more time to ride out market highs and lows.
3. Diversify
In InvestSMART’S view, there is no better risk-mitigation tool than portfolio diversification. This Nobel Prize winning strategy [8], based on spreading a portfolio across asset classes – and also within asset classes – doesn’t just lower risk, it can potentially reduce volatility.
The problem is that by their own admission, many Australians are not well-diversified. The most recent ASX Australian Investor Study found fewer than half (44%) on-exchange investors believe they have a diversified portfolio [9].
This is an area where exchange traded funds (ETFs) may be a consideration. In InvestSMART’s view, ETFs provide a quick, simple, and cost-effective way to gain diversification across asset classes and within asset classes.
While a traditional fund manager may pick 20 to 30 individual stocks, buying into a single ETF can provide exposure to hundreds of stocks across all markets, depending on the ETF chosen.
4. Rebalance portfolios – regularly
Asset allocation is not a set-and-forget task. Market movements, coupled with the tendency for investors to hang onto what they perceive to be ‘winning’ investments, can dramatically alter portfolio risk over time.
Rebalancing is the process of maintaining portfolio risk in line with an investor’s preference.
As an example, if equity markets fell 10%, a diversified, balanced portfolio with an allocation of 50% cash/bonds and 50% equities, would be underweight equities and overweight cash. The process of rebalancing could involve using cash to buy more equities. This process automatically supports the discipline of buying stocks when they are cheaper, also known as dollar-cost averaging.
The converse holds true. If the sharemarket rose 20% in a year, the portfolio would have higher overall risk. A possible solution to return risk to an investor’s comfort level is to sell equities and transfer the funds into cash/bonds.
It is worth noting that rebalancing doesn’t reduce the risk of a market downturn. Rather, it allows an investor to keep their portfolio risk in check.
How often should you rebalance? Research by Vanguard suggests rebalancing annually, minimising the impact of transaction costs and tax [10].
Conclusion
Investing by its nature involves taking risks. Higher risks may potentially be rewarded with higher returns, but also the possibility of greater losses.
What matters is that investors understand the level of risk they are comfortable with and shape their portfolio accordingly.
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[1] Source: ASX All Ordinaries Accumulation Index. 4 January 1988 - 5 November 2024
[2] ibid
[3] https://cdn2.hubspot.net/hubfs/5341408/EP_Wealth_Advisors_April2019/pdf/2016-Dalbar-QAIB-Report.pdf
[4] https://cdn2.hubspot.net/hubfs/5341408/EP_Wealth_Advisors_April2019/pdf/2016-Dalbar-QAIB-Report.pdf
[7] https://www.sciencedirect.com/science/article/pii/S0970389615000658
[9] https://www.asx.com.au/content/dam/asx/blog/asx-australian-investor-study-2023.pdf
About the author
DISCLAIMER
This article is for education purposes only. It is general financial product advice only and has not taken into account your objectives, financial situation or needs. Consider whether the information in this article is right for you. For more information on the risks and other features of InvestSMART, please review the relevant Product Disclosure Statement (PDS), Financial Services Guide (FSG), and Target Market Determination (TMD) available on www.investsmart.com.au and seek professional advice before making any investment decision. Historical performance is not a reliable indicator of future performance.
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