The math of losing … and not losing

When I launched my business way back in 2002, my motto was “minimizing risk to maximize returns.” Catchy, eh? Okay, maybe not T-shirt catchy, but not bad for the financial business. But not only is it catchy, it’s pretty fitting. That’s because simply “not losing” can have an outsized impact on your longer-term returns. Just ask Warren Buffett.

Warren Buffett, clearly one of the best investors of all time, has two simple rules for investing. Rule number 1: Don’t lose money. Rule number two: Don’t forget rule number one. He doesn’t lose a lot or for long. His holding company, Berkshire Hathaway Inc. (NYSE: BRK.A) has delivered an average annual compounded rate of return of 15.9% over the past five years, compared with 14.6% for the S&P 500 Composite Total Return Index.

Doesn’t seem like that much outperformance, does it? Well consider that back in 1964, when Buffett took over Berkshire Hathaway, it had a notional value of about US$19 per share. If your parents or grandparents had been one of the very few to own shares back then, and following Buffett’s “hold forever” philosophy, held on to them in the intervening 52 years, they’d now be incredibly wealthy. A US$1,000 investment would have given you 52 shares back then. Today, the Class A shares are worth US$218,000 each, and your 52 shares are worth US$11,336,000, a gain of 11,336%. Sure, it’s a long time, but it’s certainly a nice retirement package!

So there is something to this business of not losing, because there is a troubling asymmetry to the math of losing.

Here is an example. Let’s say you have $100,000 invested, and you lose 50%. You may think that you need to earn back 50% to be back to even. Well you’d be wrong. If you lose 50%, you will now need to double your money, and see a gain of 100% just to get back to where you started.

These numbers are pretty sobering. The thing that strikes me about this is how parabolic the required rates of return are. The relationship is not linear, and the greater the original loss, the more you will need to earn back just to get back to the starting line.

The volatility management solution

But this math of losing is the reason why volatility management and capital protection are cornerstones of my fund and ETF analysis process. Those investments that exhibit lower levels of volatility are generally favoured over those that have higher levels of volatility, all things being equal. Those funds that can protect capital in down markets are favoured over those that don’t.

In today’s low-return environment, it is much easier to gain 11% than it is to gain 43% or 100%. This underscores the importance of building a properly diversified portfolio that is in a better position to hold up when things get rocky than to go full throttle and just look for gains. By managing your volatility, within your return requirements, you are putting yourself in a much stronger position to achieve your investment goals and objectives than if you focus only on return.

Now if you will excuse me, I’m off to Dairy Queen to celebrate Mr. Buffett in another way! (For those who don’t know, and there’s no reason you should, Berkshire Hathawaypurchased International Dairy Queen back in October 1997. Want to know more about Berkshire Hathaway? Check their website for a list of its brand-name holdings.)

Courtesy Fundata Canada Inc. © 2016. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.