Never Lose Money
Let’s review Warren Buffet’s Rules:
“Rule #1: Never Lose Money.”
This might seem like a joke or something witty, because who actually sets out to lose their hard-earned money? Yet, many portfolio managers don’t fully understand this critical rule.
“Rule #2: Never Forget Rule No. 1.”
The mindset of a sensible investor must include the “math of investing” which takes us back to Rule #1. Understanding Drawdown Math is extremely critical if you want to compound your wealth. Don't gamble away your assets. Don't go into investments with a cavalier attitude that it's OK to take large losses. Do your homework and understand the simple math of drawdowns.
To Grow Your Wealth, You Must Protect It
A good analogy might be a farmer. A farmer must protect his crops so that he can grow them. He installs scarecrows to ward off birds from eating his freshly planted seeds. He puts up fencing to prevent rabbits and rodents from eating his young crops. He uses insecticide (hopefully organic) to deter insects from having a feast on his plants. Just like the farmer, we must protect our crops, in this case our investment portfolio, while we grow it. While there is no foolproof way to guarantee the safety of our portfolio, we seek to minimize risk and maximize the chances of protecting it in order to allow it to grow. The most important thing we can do to protect our investment portfolio is it to understand basic math.
The Mathematics of Drawdowns:
Consider the below charts:
This is the ugly mathematics of drawdowns.
If we lose only -10% of the value of our portfolio is not that big of a deal. We feel confident we can make back the +11% needed to get to breakeven. However, if we start losing more, the math becomes very ugly. At a -20% loss, one needs earn back +25% to reach breakeven. At -30% loss, one needs to earn +43% to reach flat; at -50% loss, one needs +100%. Pause and think about that for a moment…you need to double what’s left of your portfolio just to get back to your original amount if you suffer a -50% drawdown. That’s why Buffet’s Rule #1 and Rule #2 are so important to us.
Consider the following charts:
Actual returns from a friend’s fund. He gave up a stellar two decade track record with one bad year.
Our View
So how does one “Never Lose Money?” Well, that’s very difficult. However, we believe that one can reduce the size of large losses by incorporating certain concepts. At Jedburgh, we use a number of hedging strategies to help protect our portfolio from large downside deviations. To help protect our portfolio we incorporate the following: finding correlated assets to go both long and short, trailing stop-loss orders, protective put options and reducing both gross and net exposures when conditions merit. However, it is important to remember that these strategies may also limit our portfolio’s upside potential, but given the ugly math of drawdowns, we believe that they are worth it.