On the Wisdom of Cowardice

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Warren Buffett has so many great quotes. There’s the one about how idiots eventually run good companies. 

There’s that other one about today’s shade coming from a tree planted long ago. 

He’s a folksy guy and damned smart, so his quotes are like little Yogi Berra gems without all of the unintentional irony. 

But of all of his quotes, the most famous one is this one, I think. 

Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.

It’s got all of the essential ingredients for a great quote. Deceptive simplicity, humor, and profundity. 

If you are like me, then when you first heard the quote you probably thought “that’s clever!” And as you thought about it a little more it occurred to you that there was likely some fundamental and important truth concealed within it. But then you probably dismissed it, thinking that there was little actionable intelligence to be gleaned from it. 

My feeling is that we were on the right track right up until we dismissed it. I’ve come to the conclusion that this simple rule is as advertised, the one essential rule that we have to obey in order to invest well long-term. 

Why is this so?

There are a number of answers to that question, like…

  1. Compounding wealth is slow and tedious, but losing wealth is fast and violent.
  2. Downside volatility is much more destructive than upside volatility is constructive. (I.e. if you lose 50% of your net worth on Monday, you must gain 100% of your net worth on Tuesday in order to get back to even.)
  3. If you don’t make money quickly, you can remain in the game.  But if you lose money quickly you may be forced out of the investing game. (And compounding requires, above all else, time to work its magic.)

But before this post degenerates into a long list of empty nuggets of “wisdom,” let’s flesh this out a bit with a theoretical example. 

Imagine 2 investors starting out their portfolios.

The first investor is brilliant. He is a quick thinking Ivy League educated Quant with a lot of useful contacts. He is so clever that he is able to take more risk and beat the market by 50% each and every year. The only downside to his brilliance, is that during bear markets his increased exposure to risk means two times deeper losses than the market. We will call this investing genius “Rabbit.”

The second investor is not so exceptional. In fact he is average in every way. He did two years at the local community college and finished up his degree commuting to Big State U.  He was the first in his family to go to college so he doesn’t have many contacts in the know.  He takes exactly as much risk as the market and matches the market in returns each and every year. ( Truth be told he simply buys a low-cost S&P 500 index fund, and spends the rest of his time writing screenplays.) So when the market goes up, so does his portfolio, and when the market goes down, his portfolio moves in lockstep. We will call this average investor, “Turtle.”

Both investors start with $10,000, and they are blessed to begin their investing careers with 9 straight years of a raging bull market. Each year the market gains a cool 10% in total returns. 

So at the end of nine years, Turtle is thrilled that his 10% compounding growth has yielded him a total of $23,579.48. Not bad. Not bad at all.

But Rabbit is even more thrilled. His nine years of 15% compounding growth have grown his original $10,000 to $35,178.76!

Unfortunately on the 10th year, there is a minor financial crisis and the market loses 25% of its total value.

So after turtle has taken his 25% haircut he is left with $17,684.61. Which makes him feel fairly disheartened.

But not nearly as disheartened as rabbit whose 50% haircut has left him with $17,589.38. 

So after nine years of significant over performance, (and only one year of significant underperformance) Rabbit is left with less money than Turtle.

tortoise_&_hare_1There’s an allegory in there somewhere…

This is a nonlinear and non-intuitive result. It seems analogous to the Giants beating the Dodgers nine games out of 10 by one run, then losing the 10th game by two runs, and finding out that they (The Giants) have lost the series. 

But I think this surprising result describes well the unbalanced risk/reward relationship central to investing money. Simply put, we should spend most of our energy avoiding big losses, rather than chasing big gains. There’s more bang for our buck with such a strategy.

But knowing that avoiding losses is a good idea is not the same as avoiding losses.

What Buffet’s golden rule suggests to me, is that when choosing an investment strategy it makes more sense to focus on the downside than the upside.

So backtesting metrics like the worst year’s returns, tells us much more about a strategy than the best year’s returns. (My favorite metric is maximum drawdown.) Similarly a strategy’s volatility can clue us in to its underlying susceptibility to negative outcomes (though volatility does not tell the whole story about risk.)

Buffet’s insight also gives birth to some pretty useful golden rules to consider when evaluating new investments and strategies, such as…

  • Avoid leverage whenever possible. (Debt makes you very vulnerable to random and unpredictable outcomes.)
  • Prioritize asset liquidity (to avoid getting stuck in a bad investment, long after it has declared itself to be a loser.)
  • Favor strategies that allow for flexibility in times of crisis.
  • Search out strategies with clearly defined downsides, (and if possible) unlimited upsides.

In the coming weeks, I will write about several investment approaches that I believe have the potential to obey Warren Buffett’s golden rule.

This series will run in parallel with my ongoing series on manufactured spending.

So stay tuned!

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