Two of these portfolios were professionally managed. The third, which was self-directed and the worst performing one, had far too much risk and suffered two margin calls in July and October , ending in a forced sale of investments at a significant loss.  The other two portfolios were concentrated in the worst performing sectors of last year: technology and China.

Permanent loss of capital is the one outcome that investors must avoid at all costs.  You want your money to grow, not disappear into the abyss. 

Buying a China real estate developer bond at 102 and then selling it at 30 locks in a permanent loss which is difficult to recover from.  Buying funds after they’ve had a long stellar run and everyone is recommending their track record, and then selling when they suffer a big negative year similarly results in permanent loss. 

Past high returns are no antidote. Three years in a row of +90% returns will make the investor look like a genius, but if the fourth year is -90%, all gains and more are lost, with the portfolio well below the initial starting amount.  The investing world graveyard is full of once high-flying managers that lost nearly everything during a market crash.  Inevitably a weak mea culpa investor letter follows that essentially says ‘no one could have seen this coming’. The fund manager often comes out of the rubble okay after charging management and performance fees for years, but his investors don’t (see the last point at the end of this article).

Earning 20% annual returns for three years and then losing -50% on year four wipes out all the previous gains and results in a net loss on the original invested capital. This return profile is extremely common in investment portfolios that come to us after suffering the big loss at the end. Such a portfolio underperforms even a stable 5% annual return that loses -10% on year four, which  still shows a gain at the end of the period.

Avoiding this terrible outcome is not difficult, investors just have to remember the following:

1. Don’t put all your eggs in one basket. We’ve all heard this before, that a well-diversified portfolio is the way to go. Yet many don’t know what this actually means in practice. Having Tencent, Alibaba, and Baidu in your portfolio offers no diversification. Real diversification means spreading investments across stocks, bonds, real estate, commodities, and uncorrelated strategies like volatility tail risk and managed futures. 

Additionally, investments need to be diversified across different geographical locations, industries, and company size. Think of it this way, if one of your investments goes bad, you’ll still have other eggs to cook with.

Think your portfolio is diversified? Look at your end January statement, a month when investments across many assets had very strong gains. If you’re still down more than -8% compared to 13 months ago, you’re not diversified.  Well diversified portfolios are only down around -3% to -4%, and will soon be at all-time highs again.  Portfolios that lost -40% or more last year will take years to come back.

Or you can take the opposite view, that diversification is for ‘cowards’, and the only way to outperform the market is to take concentrated bets with conviction. This is true, with one caveat: only if you know what you’re doing. 

2. Don’t time the market. We’ve all read this too, and yet how many became convinced at the end of 2022 that a big recession was just around the corner when reading all the negative reports from economists and research outlooks, and kept significant cash on the side-lines instead of investing it? The strong performance of investments in January don’t mean that a first-half 2023 recession won’t happen, but it does show the mistake of thinking the markets will drop and you will be able to get in at a lower price.  Wrongly timing the markets leads to permanent loss of capital.

3. Be careful of leverage. Borrowing to increase your returns disproportionally increases the volatility, exposing your portfolio to risk of a margin call and permanent loss of capital.  Portfolios that leverage 50% to 100% are guaranteed to lose everything in the next downturn. 

4. Keep emotions in check. Investing with emotions is like driving with a blindfold on. You may feel like you’re in control, but you’re not. Emotions will cloud your judgment and lead to bad decisions, such as selling low and buying high. Stay disciplined and stick to your investment plan, no matter what the market is doing.

5. Don’t chase after the hottest investment. Everything reverts to long-term averages, always. In 2021 a smart investor said Bitcoin will not make you 20,000,000% in the next decade, as it did in the previous one. Indeed, bitcoin has fallen 66% since then.  Keep greed in check, there are no shortcuts to building sustainable wealth from investing. The majority of investors in a hot sector get in near the top, and then end up selling near the bottom: permanent loss of capital.

6. Do your research. This is not just about the stocks and bonds you buy. If you invest mainly via ETFs, which most investors should do, the research part is straight-forward. If a bank or independent investment manager looks after your portfolio, it is critical to research the firm and person managing your money.  Two of the portfolios that suffered losses of -40% last year that I mentioned earlier were managed by professionals. Professionals are humans after all; they can, and often do, make some of the similar mistakes that retail investors make. 

Ask your investment manager how they manage their own money. Then ask them how they protect your portfolio when a financial crisis hits. You’d be surprised at how many active managers, when promised anonymity, say that they invest all their money via passive ETFs. You’d be even more surprised at how many say they would not invest into their own funds.