You Can't Have All the Upside and None of the Downside

"Investors expect better than index returns, but aren't willing to suffer bigger than index losses." - Rob Isbitts

Rob Isbitts' quote captures one of the great contradictions in investing. Every investor wants to outperform the market, but very few are willing to accept the additional risk that often comes with trying to do so.

Anyone who has worked with individual investors has seen this firsthand. Clients want to participate in every rally, but they become uncomfortable the moment markets begin to pull back. They want all of the upside and none of the downside. It's an understandable desire, but it's not how investing works.

One of the biggest differences I noticed between institutional investors and individual investors was their appreciation for the relationship between return and risk. Institutions understood that if you're investing in risk assets like stocks and equity ETFs, you're accepting the possibility of drawdowns along with the opportunity for long term gains. Higher expected returns don't come without volatility, headline risk, macroeconomic risk, currency risk, and a host of other uncertainties.

You can't have all the upside and none of the downside. But there are ways to move closer to that ideal.

While it's impossible to capture every bit of upside and avoid every bit of downside, there are ways to move closer to that ideal. The first is learning to stay with winning positions longer. One of the most common mistakes I see is selling too early. There are few experiences more frustrating than taking a quick 20% or 30% gain, only to watch the stock double or triple after you've exited the position.

Peter Lynch used a wonderful gardening analogy to describe this behavior. He said many investors pull their flowers and water their weeds. Instead of nurturing the positions that are performing well, they sell them too quickly. Meanwhile, they continue holding losing positions, hoping they'll eventually recover. It's exactly the opposite of what a healthy investment process should encourage!

Trend following provides a practical solution. By using tools such as moving averages or simply observing the pattern of higher highs and higher lows, investors can stay with an uptrend as long as it remains intact. The objective isn't to sell at the highest possible price. It's to remain invested while the evidence continues to support the trend.

Stop pulling your flowers and watering your weeds. Stay with what's working.

Managing downside risk requires the same level of discipline. One of the biggest behavioral challenges investors face is becoming emotionally attached to a position. Psychologists call this the endowment effect. Once we own something, we naturally place greater value on it, making it much harder to sell even when the evidence suggests we should.

That's why money management rules matter so much. Trailing stops, moving averages, and techniques like the Chandelier Exit give investors an objective framework for recognizing when an uptrend has transitioned into a downtrend. Rather than relying on emotion, these tools encourage us to respond to what the market is actually doing.

Discipline replaces emotion. That's what money management rules are built for.

We'll never experience all of the upside and none of the downside. That's simply not how markets work. But by following strong trends with patience and managing risk with discipline, we can give ourselves a much better chance of participating in major advances while avoiding the worst of prolonged declines.

Mindless investors sell their winners too early, hold their losers too long, and let emotion override their investment process.

Mindful investors stay with healthy trends as long as they persist, manage risk objectively, and recognize that superior returns require both patience on the way up and discipline on the way down.

RR#6,
Dave

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Disclaimer: This blog is for educational purposes only and should not be construed as financial advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. The author does not have a position in mentioned securities at the time of publication. Any opinions expressed herein are solely those of the author and do not in any way represent the views or opinions of any other person or entity. For full disclaimer, please see our website: marketmisbehavior.com/disclaimer.