The Unfortunate Math Behind Market Losses
Warren Buffett has often discussed his two rules of investing. 1) Don’t lose money. 2) Don’t forget rule #1. That seems basic enough, right? Well, it’s often easier said than done….
To elaborate on this point, there’s some rather simple and unfortunate arithmetic behind this thinking. See the graphic below for a basic outline of the gains required to overcome investment losses. As you can see, the deeper the losses the less likely you are to recover those losses as they require ever increasing gains just to break-even.
I got to thinking about this as I read this article at CNBC about John Paulson’s Advantage Fund and its -62% return over the last two years. A -62% loss requires a 165% just to break-even.
Good lucking planning for retirement with that kind of volatility in your savings portfolio….
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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10 Comments
Interesting math, but I don’t think Buffett was thining about price declines, but permanent imparement of capital.
I must say, though, that I give credit to Paulson for not (yet) shutting down and just opening another fund. It must be hard to retain analysts who know they’re not getting any performance bonuses until they gain 165%.
Is that how hedge fund compensation is structured?
Yes. Actually Paulson and team are the biggest investors in their funds (probably 50% of assets), so it is not worth liquidating for them, I guess.
Thank you.
Seems like an even better reason to liquidate. They’re losing their own money hand over fist!
Add inflation to it as well. The Wall Street Journal had an article about this a few months or maybe a year ago. The market hit its high in 2007 and then dropped. Now it’s back up again. Factor inflation into it, and it really isn’t all that great. Inflation is very low, but it does eat away at returns. After being down for two years with Paulson, figure the opportunity cost as well as inflation when and if it ever comes back.
Not hard retaining the bad ones though, they have nowhere else to go.
Subtext is that he employs bad ones already hence the substandard returns.
Some points on Paulson:
- The fund that lost 62% is the leveraged milti-strat event driven fund; he runs also a non-levered version that has lost 46%
- Paulson’s merger arb fund (which is his core expertise) is down only 5.6%
- Paulson made the wrong bets in 2011, investing without hedges in banks and gold stocks, relying on “recovery” and “inflation”; the first suffered due to the EU crisis, the second due to peculiarities of gold stocks vs. gold price / no inflation acceleration (misunderstanding of the monetary system)
- A bigger problem for Paulson is his style drift (into macro, equity hedge) and hubris after his great 2007-2008 calls
62% ouch! Better to cut your losses early and survive to trade/invest another day.