Investing is all about making returns, so ideally, we want to find investments that will help us grow our wealth the most.
That doesn't mean every investment we make needs to be an all-or-nothing gamble. But it's good to remember that the best-returning businesses are ones that have delivered lots of earnings growth, such as WiseTech Global Ltd (ASX: WTC), REA Group Ltd (ASX: REA), and Pro Medicus Ltd (ASX: PME).
It'd be great if every single investment went perfectly, but investing doesn't necessarily work out like that.
One or two bad investments shouldn't put us off investing.
Stick with investing
One of the world's greatest investors was Peter Lynch, who achieved an average annual return of approximately 29% over a 13-year period for the Magellan Fund at Fidelity.
It's extremely difficult to earn annual returns of at least 20%, and we shouldn't expect to be able to make that much with our own portfolios.
But I'm going to refer to some advice that Lynch once gave about experiencing winners and losers.
Peter Lynch said that successful stock picking will involve some bad investments. He said that, as an example, "two stocks will give the most returns, six stocks will perform in line with the market and two stocks will underperform". He also said:
All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don't work out.
Let's imagine we own three ASX shares with good long-term (earnings) growth prospects. Over one year, company A returns 80%, company B returns 10% and company C falls 30%. The average return across the three is 20%, even though one has dropped 30%. A 20% return is probably going to be a market-beating return.
The most a share price can drop is 100%, whereas good companies can rise 200%, 300%, or more over time.
Of course, not everyone may have the time, skill or inclination to pick individual ASX shares. Hence, I think it'd be better to invest in diversified exchange-traded funds (ETFs) than avoid investing in shares altogether.
Loss aversion
The concept of loss aversion is that we feel pain more than gain. Looking back 10,000 years, avoiding 'loss' of some kind could have meant the difference between life and death. It would have been important to avoid losses in life back then!
However, as I've discussed above, letting loss aversion rule our financial choices in the share market could lead to inferior results.
Schwab Asset Management points out how this can be a problem:
…the second half of 2022 saw significant volatility, with the S&P 500® Index dropping more than 10% between August and October. Those losses might have led some investors to believe the worst was yet to come; however, if they were not invested in January 2023 they might have missed out on the S&P 500's 15% returns by early August.
Nobel Prize–winning economist Daniel Kahneman illustrated the psychology of loss aversion bias in a simple experiment with his students: he told them that if a flipped coin lands on tails, they would lose $10. Then he asked them how much they would need to win to make the coin flip worth the risk of losing $10. The answer, he said, was typically more than $20.
Being brave and sticking with investing through market volatility can help produce the best wealth creation over time.
