Over the years, I’ve found that most investors believe that the process of achieving high returns tends to be through the process of addition. Everywhere you turn there is an advisor or commentator recommending that you buy one thing or another to add to your portfolio.
What many investors don’t realize is that there are times when the process of subtraction can be a better strategy. In simple terms, the subtraction process means avoiding investments that are losers.
To put this in perspective, if we were to place all available investments on a graph and plot their returns, you would have the majority of the returns fall within the average range. The remaining few would either be at the extreme high end and at the extreme low end. This would appear as a bell shaped curve on the graph.
Most investors go into the market with the intention of making great investments and achieve returns that are higher than average. Keep in mind however that when you strive towards reaching higher than average returns, you are also taking a more probable risk that you will fall below the average.
We all want to make great investments, but a more practical approach would be to focus on not making investments that will be losing propositions. Imagine the bell curve on the graph again. This type of approach would appear as a bell curve with the left side cut off.
If it does what it is supposed to do, you will see the largest cluster of investments achieving small gains, a few good returns and a lesser amount of exceptional returns. The important part of this to see is that the average return would increase.
A good example of how subtraction works is bond investing. For the sake of illustration, we are going to be assessing a variety of corporate bonds with a 5% yield at maturity. What would be the best approach?
If everything goes as planned, an investment in a corporate bond with a yield of 5% at maturity will result in a 5% yield at best.
However, if it does not perform as expected, the potential loss can be far greater than what we hoped to have gained. So, it seems that the simplest and most prudent approach would be to avoid investing in bonds that appear to currently have a 5% yield, but will not pay as expected when all is said and done.
I challenge you to consider this subtraction approach in your investments. For those applying this to equity markets, make sure to examine your own portfolio first. It may turn out that the best move is selling an existing holding that may not be profitable in the future and not adding anything else to your portfolio.
With new investments, figuring out which investments may be losers depends greatly on the specific investment being considered.
Keep in mind that no strategy is going to apply to every single case, but keeping this in mind will put you far ahead of almost everybody else.
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