Investment Rule #1 – Avoid Large Losses

Having just taken it on the chin on an equity investment that I had a reasonable position in, this rule gets to kick off a new series of posts that will consolidate some hard-earned lessons for posterity.

In essence, Investment Rule #1 stems from the principle that it is harder to accumulate capital than it is to lose it.

Taking our lead from James Montier (here or in PDF here), a large, realised loss gives us the purest definition of ‘risk’:

“The permanent impairment of capital can arise from three sources 1) valuation risk – you pay too much for an asset 2) fundamental risk – there are underlying problems with the asset that you are buying 3) financing risk – leverage.”

It is the probability of one or all of these risks being realised, thereby giving rise to a permanent loss of capital, that must be understood in making an investment.

(Note that permanent loss of capital does not require that an investment falls to zero – it includes mark-to-market losses that are realised for whatever reason.)

We will explore the various types of risks in latter notes – for the moment there are some key things to consider with respect to this particular rule:

1) Size an Investment According to Its Expected Volatility

Given an understanding of the risk and reward around any investment, the actual size of a position should be scaled according to the range of outcomes that could arise. In other words, if there is a reasonable probability of an investment falling in value by a relatively large percentage, then the investment should be a smaller proportion of your portfolio. In this way, the risk of large ‘permanent’ losses is reduced.

2) Use Leverage Sparingly, if at All

Leverage, by definition, will increase the volatility of returns on an investment, so point 1 immediately applies. Leverage will also introduce another party into your investment decisions. And unless you have remarkable powers of persuasion, they are unlikely to have the same risk appetite as you – as one particularly apt financial proverbs goes “a banker will gladly lend you an umbrella until it starts raining”. Keep leverage in investing for those occasions where the odds are heavily stacked in your favour.

3) Invest According to Your Time Horizon

Illiquid investments, whether they be small-cap equities or farmland destined to be rezoned, require patient capital. More patient, than most investors, are capable of. The point is that the horizon of an investment must be matched to its nature. Selling an illiquid investment in haste rarely maximises its return.

4) Always Assume the Worst

This is perhaps the most important part of this rule and yet the hardest to apply. While humanity has a great capacity to imagine the future, my sense is that most of us are optimists. We at least hope for the best, if not expect it. Without this faculty, the world would probably be a pretty dreary place – assuming we had climbed far enough up the food chain to recognise it was cold and grey and lacking in iPads…

The point is that in investing, to stack the odds in our favour, we should always assume the worst. This will clearly cut down the investment universe – you will miss crazy investment successes, but let’s face it, you would have probably missed them anyway. (The best risk/reward investments are most often those that relate to your direct experience. If you hear about a great investment from the shoeshine, you are more likely to be the poor sod who provides the ‘exit strategy’ for those closer to the action.)

But most importantly you are more likely to miss the duds. And remember it is the failures that will destroy investment performance.

Now as to my hit this week, that was via an equity investment where I had ignored point 4. In essence, I had disregarded the warning signs (and they were sufficient for an investor who ‘assumes the worst’).

It all came down to how one interprets the communique from management but that is for rule #2…