Losses are in the news after a large hedge fund took a multibillion-dollar loss.

Hedge fund managers, aka hedgies, are smart; just look at the profits that former hedgie Paul has delivered to subscribers of his newsletter. However, sometimes hedgies ignore math and do dumb things.

In this case, hedgie Bill Ackman’s Pershing Square Capital Management will need to gain more than 400% to recover from the 80% loss he recorded on Valeant Pharmaceuticals International Inc. (NYSE: VRX). The chart below shows the size of the gain needed to recover from different losses. Notice that losses of more than 30% are difficult to recover from.

gainsneededSome investors like to ignore losses, claiming that a stock’s decline doesn’t really become a loss until they sell.

This idea ignores the reality of the stock market. My broker values my account based on the market prices of the positions I hold, and I’m certain your broker does the same. A loss is real whether I sell or not. Ignoring it and refusing to sell risks even more money.

Let’s say I bought a stock for $10, and it falls 50% to $5. I now need a 100% gain to break even.

Being perfectly honest, if my timing was so bad that the stock dropped 50% after my buy, there is unlikely to be a catalyst driving a 100% gain anytime soon.

In the Valeant trade, Ackman lost an estimated 81% on his position. Because of some derivatives he held on the stock, the actual loss might be more than 100%. His refusal to take a small loss cost his investors at least $3.7 billion.

To break even after this trade, Ackman will need to generate a gain of 426%. If he delivers an average gain of 18% a year, his investors will be back to even in 10 years. At 10% a year, it will take a little more than 17 years to break even.

That’s bad, but the reality is that the loss is even worse than that. Let’s say he does break even in 10 years. Without the gigantic loss, investors would have had a 292% increase in wealth. A $1,000 investment would be worth nearly $3,000 instead of just breaking even.

Large losses destroy wealth and can prevent you from reaching your financial goals. Cutting losses is one of the keys to growing wealth — unless you manage a hedge fund. Despite his loss, Ackman is still earning hundreds of millions of dollars a year in management fees.


Michael Carr, CMT

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