The Great Investment Truth Behind Simple Arithmetic

Rule No. 1: Don’t Lose Money

Rule No. 2: Don’t Forget Rule No. 1

 – Warren Buffett

When I first read this quote from the richest man in the world (or second-richest, depending on the relative performance of Berkshire Hathaway (NYSE: BRK-A, BRK-B) and Microsoft (NYSE: MSFT) stock at any particular moment), I thought it was stupid. If you invest in stocks – which most of us do in order to beat inflation and build wealth for retirement — it is an impossible goal to have a 100% success rate. The future cash flows of companies are simply too uncertain to always pick winners.

Is Buffett a Hypocrite?

Buffett himself has failed to follow his own rule. During the stock market collapse of 2008-09, he lost 20% of his net worth ($10 billion) as Berkshire Hathaway stock fell along with the market. He’s also lost money on individual stocks within the Berkshire portfolio. In his 2008 letter to Berkshire shareholders, he admitted that he had lost “several billion dollars” buying oil company ConocoPhillips (NYSE: COP) when oil prices were near their peak and lost 89% of his investment in two Irish banks.

No, He’s Not

Warren Buffett clearly isn’t stupid (if he is, I want a big slice of whatever dumbass pie he eats alongside his cherry coke and cheeseburger), so I’ve reinterpreted the meaning of his quote to mean: “focus your investing efforts on preventing big losses.”  Buffett certainly isn’t the first person to say such a thing and won’t be the last. More than a hundred years ago steel magnate Andrew Carnegie voiced the famous line: “watch costs and the profits will take care of themselves.” More recently, legendary short-term trader Paul Tudor Jones stated: “I’m always thinking about losing money as opposed to making money. Don’t focus on making money, focus on protecting what you have.” The concept seems to apply to any realm of business devoted to wealth generation.

Simple Arithmetic Explains All

What is it about losses that have all of these wildly successful and wealthy people so concerned? After all, you’ll have plenty of winning investments to balance against your losers. Why not just focus on finding winners, losses be damned? As with most great truths, the answer is incredibly simple. It comes down to basic arithmetic that we all learn in grammar school, yet many seem to forget when investing.  Here it is:

Gains and losses of equal percentage magnitude have asymmetrical effects on wealth, with losses having the greater effect.

That’s it.  That’s the great truth.  Take a look at the following chart:

Loss/Gain Asymmetry

At small levels of loss, the gain needed to break even is relatively the same. So if you lose 1/10 (10%), it only takes a gain of a little more — 1/9 or 11% — to make it back to even. But it’s a whole different ballgame at larger percentage losses. By the time you lose 5/10 (50%), it takes 5/5 — a double — to break even. I don’t have to tell you that it is a heck of a lot easier to lose 50% than it is to gain 100%.  And if you are one of those hopeful “its going to come back” type of persons who refuses to sell an investment at a loss, you could easily end up watching your stock fall 80% or even 90% (e.g., Enron, WorldCom, Lehman Brothers), which would require a virtually impossible gain of 400% to 900% to break even.

Now you know why the great investors care more about preventing losses than securing gains — losses are much more damaging than gains are helpful.

Volatile Returns are Damaging to Your Wealth

And this is also why the range of your returns is much more important than your average return.  If I gave you a choice between an investment that offered an average annual return of 6.25% and one that offered “only” a 3.00% annual return – less than one half as large – I’m pretty sure you would pick the 6.25% investment.  But before you reach such a conclusion, you should inquire as to how frequently and to what degree the investment loses money in a given year. For example, assume the two investments produce the following returns over a four-year period:

Investment No. 1 loses money in two out of four years, whereas Investment No. 2 never loses money.  These losses are very damaging to the owner of Investment No. 1. Despite having a much higher average return, Investment No. 1 has a lower compounded annual return than Investment No. 2.  Geometric compounded annual returns – which multiply the four returns together rather than simply adding them and dividing by four — take into account the asymmetry of gains and losses and are what count when measuring wealth accumulation.

Take it from famed value investor Seth Klarman in his out-of-print investment classic “Margin of Safety”:

It is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success. In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal. An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.

So the next time a mutual fund or an investment advisor trumpets their average returns, be very skeptical. Insist that that they provide you with not only their geometric compounded returns, but also the range of their returns so you can see exactly how often – and to what degree — they incur damaging losses.

Screening for Loss Minimizers

I performed a mutual fund screen that looked for funds that are successful at minimizing losses.  Specifically, I filtered for funds that met the following criteria:

1. Three-year and five-year downside capture ratios of 90% or less
2. Three-year and five-year upside capture ratios of 110% or more
3. Three-year alpha greater than zero
4. Expense ratio less than 1.5% per year
5. Minimum initial purchase requirement of $10,000 or less
6. Current manager has been at the helm for at least five years

A 90% downside capture ratio means that the fund lost only 90% as much as its benchmark index per month during declining markets and a 110% upside capture ratio means that the fund gained 110% as much per month as the index during rising markets. Alpha measures the degree to which the manager outperformed the benchmark index.

Here are the results of the screen:

Keep in mind that these are not recommendations. Screens are useful as a first step to narrow down the list of investment opportunities but then additional research is required to make a final decision.

Don’t Forget Your Feelings

Oh, and there is a completely non-mathematical reason to minimize losses – psychology. Have you ever lost a lot of money in the market and felt so bad that you take a break from investing to recover? I sure have and it is usually just when the market takes off again to the upside.  As Seth Klarman (this guy must be good for me to keep quoting him) aptly notes:

Losing money can be psychologically unsettling. Anxiety from the financial damage caused by recently experienced loss or the fear of further loss can significantly impede our ability to take advantage of the next opportunity that comes along.

There you have it. Be cautious. Minimize risk. Your portfolio – and your psyche — will thank you.

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