{"id":24548,"date":"2011-10-18T08:00:23","date_gmt":"2011-10-18T12:00:23","guid":{"rendered":"http:\/\/countingpips.com\/fx\/2011\/10\/18\/want-to-avoid-blowing-up-like-paulson-dont-forget-buffetts-two-rules\/"},"modified":"2011-10-18T08:00:23","modified_gmt":"2011-10-18T12:00:23","slug":"want-to-avoid-blowing-up-like-paulson-dont-forget-buffetts-two-rules","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/fx\/2011\/10\/18\/want-to-avoid-blowing-up-like-paulson-dont-forget-buffetts-two-rules\/","title":{"rendered":"Want to Avoid Blowing Up Like Paulson? Don\u2019t Forget Buffett\u2019s Two Rules"},"content":{"rendered":"

By The Sizemore Letter<\/a><\/p>\n

\"\"<\/a><\/p>\n

Is it December 31 yet?<\/p>\n<\/div>\n

John Paulson must be breathing a small sigh of relief.\u00a0 The recent bounce in the prices of bank stocks and gold has, at least for the time being, stopped the bleeding.\u00a0 The patient, alas, is still in critical condition.<\/p>\n

It\u2019s been a rough year for the hedge fund legend.\u00a0 According to the Financial Times<\/em>, Mr. Paulson\u2019s flagship Advantage Plus fund was down 47% for the year (see article<\/a>).\u00a0 The unleveraged version of the fund\u2014ostensibly more conservative\u2014was down by \u201conly\u201d a third.<\/p>\n

I\u2019ll refrain from kicking Mr. Paulson while he\u2019s down.\u00a0 I\u2019ve learned the hard way that the market gods tend to smite the arrogant.\u00a0 And as an investor, I\u2019ve certainly made my share of bad trades over the years.\u00a0 We all <\/em>have.\u00a0 Everyone.\u00a0 Yes, even demigods like Warren Buffett, and we\u2019ll get to him a little later.<\/p>\n

The problem, as Mr. Paulson is no doubt painfully aware, is that it is hard to recover from a loss of nearly 50%.\u00a0 In order to get back to break even you have to double<\/em> your money, and that\u2019s not particularly easy to do in a short period of time.<\/p>\n

Take a look at Figure 1.<\/strong>\u00a0 This chart shows the subsequent gains that you\u2019d have to earn in order to recover a given loss.\u00a0 A 10 percent loss requires only an 11 percent gain to get back to break even. \u00a0A 20 percent loss requires a slightly higher 25 percent to recover.<\/p>\n

\"\"<\/a><\/p>\n

Figure 1<\/p>\n<\/div>\n

But now take a look at the bottom of the chart.\u00a0 A 90 percent loss requires a 900<\/em> percent gain to break even.\u00a0 A 99 percent loss requires an almost unfathomable 9,900 percent rise.\u00a0 Suffice it to say that, while 90 and 99 percent losses are unfortunately quite common, 900 and 9,900 percent gains are exceptionally rare.<\/p>\n

\"\"<\/a><\/p>\n

The Sage of Omaha<\/p>\n<\/div>\n

This is what prompted Warren Buffett to pen his first two rules of investing:<\/p>\n

    \n
  1. Don\u2019t lose money.<\/li>\n
  2. Don\u2019t forget the first rule.<\/li>\n<\/ol>\n

    John Paulson broke Mr. Buffett\u2019s two rules by making an enormous bet on an inflationary boom and by failing to ask that all-important question:\u00a0 What if I\u2019m wrong?<\/em><\/strong><\/p>\n

    Paulson had roughly 30 percent of his fund in financials, 15 percent in materials, and 9 percent in oil and gas.\u00a0 (See John Paulson\u2019s current portfolio holdings <\/em>here<\/em><\/a>.)<\/em><\/p>\n

    Paulson also happens to be the largest shareholder in the SPDR Gold Trust (NYSE: $<\/span>GLD<\/a>)<\/strong> and is so enamored with the yellow metal that he offers his investors the opportunity to denominate their shares in gold. (Though this was a savvy marketing ploy, it has absolutely no real value.\u00a0 It doesn\u2019t matter what \u201ccurrency\u201d you report on your quarterly statements.\u00a0 Returns are returns.\u00a0 Paulson\u2019s clients who chose to denominate their account in gold took losses every bit as large as those that denominated in dollars.)<\/em><\/p>\n

    The problem was not so much that Paulson invested heavily in banks; he certainly wasn\u2019t the only investor to believe that American banks were undervalued at the beginning of this year.\u00a0 The problem was that his entire portfolio was one big bet on an inflationary boom.\u00a0 His portfolio holdings were highly correlated to each other and highly dependent on the same macro forces.\u00a0 He had practically no exposure to anything <\/em>that might do well should inflation fail to materialize\u2014such as high-dividend stocks, utilities, pharmaceutical, etc.\u00a0 And to make it worse, he did it with leverage.<\/p>\n

    This isn\u2019t sound portfolio management; it\u2019s gambling<\/strong><\/p>\n

    There is nothing inherently wrong<\/em> with a little gambling, of course.\u00a0 A cynic could argue that all <\/em>trading and <\/em>investing is nothing more than gambling, and to an extent that is true.\u00a0 Risk is certainly part of the game.<\/p>\n

    Good investors\u2014and good gamblers too, for that matter\u2014practice risk control.\u00a0 Whether through careful use of position sizing, diversification, hedging, keeping cash in reserve, or even tools such as stop loss orders, they have processes in place that prevent an investing mistake from turning into a catastrophic loss they may never recover from.<\/strong><\/p>\n

    If you want to avoid finding yourself in Mr. Paulson\u2019s predicament, remember Warren Buffett\u2019s two rules.<\/p>\n

    This article first appeared on MarketWatch.<\/em><\/p>\n

    If you liked this article by Sizemore Insights<\/em>, you\u2019d probably enjoy The Sizemore Investment Letter<\/em>, our premium members-only newsletter. Click here<\/a> for more information.<\/p>\n","protected":false},"excerpt":{"rendered":"

    By The Sizemore Letter Is it December 31 yet? John Paulson must be breathing a small sigh of relief.\u00a0 The recent bounce in the prices of bank stocks and gold has, at least for the time being, stopped the bleeding.\u00a0 The patient, alas, is still in critical condition. It\u2019s been a rough year for the … <\/p>\n

    Continue reading “Want to Avoid Blowing Up Like Paulson? Don\u2019t Forget Buffett\u2019s Two Rules”<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[],"tags":[],"class_list":["post-24548","post","type-post","status-publish","format-standard","hentry"],"_links":{"self":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts\/24548","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/comments?post=24548"}],"version-history":[{"count":0,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts\/24548\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/media?parent=24548"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/categories?post=24548"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/tags?post=24548"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}