The First Rule of Investing

“The first rule of investing is don't lose money. The second rule is don't forget Rule No. 1.” - Warren Buffet


I don't post this to be cute or trite. It is a simple law of mathematics that losses degrade portfolio returns and large losses can be fatal. Let's take a look at an example: the investor who gains 20% per year for three years in a row. What is his annual compound gain? Why 20% of course. Now let's throw in a mild 20% loss (bear markets are usually much harsher than this). What is his annual compound gain now? It's only 8.43%. LOSSES DO IMMENSE DAMAGE TO COMPOUND RETURNS, and compound returns are the only kind an investor can eat. (Arithmetic returns are meaningless.)

By now everyone should be saying to themselves "Hey! What about the kind of market losses we have seen recently? What of 50 and 60% losses?" Well those are of the fatal or near fatal variety. From the Financial Life-Cycle Planning blog(dshort.com), the following chart:




It takes a 25% gain to recover from a 20% loss. It takes a 33% gain to recover from a 25% loss. But when your loss is 50% you need to DOUBLE your money to be made whole. And when your loss reaches 60% you need a 150% gain to break even!


Unfortunately, these are the kinds of losses we have seen twice in the past nine years. No wonder investors are wondering how they are ever going to make them back up.

I believe that many investors would benefit by holding a portion of their portfolio in strategies that are uncorrelated to the broader markets: absolute return strategies. These smooth returns. In choppy markets they may also provide a way to gain positive returns, not just break even. Consult your financial advisor for discussion of vehicles that may be appropriate to your situation.