HOW TO AVOID GETTING YOUR “FACE RIPPED OFF” (STRONG LANGUAGE – NSFW)

“‘If you fuckin’ buy this bond in a fuckin’ trade, you’re fuckin’ fucked.’  And “If you don’t pay fuckin’ attention to the fuckin’ two year, you get your fuckin’ face ripped off.’  Noun, verb, adjective.  Fucker, fuck, fucking.  No part of speech was spared.  His world was filled with copulating inanimate objects and people getting their faces ripped off.”

-Michael Lewis, Liar’s Poker

It’s probably the greatest worry of any investor – losing an incredible amount of money in a very short period.  As it might be assumed, getting your “face ripped off” or “blowing up” or any of the other lovely synonyms for losing a boatload of money on Wall Street, is not pleasant.  It can be career ending (or in John Meriweather’s case, career STARTING).  It can be devastating at a personal and psychological level.  But it happens quite regularly.  Despite seeing these occurrences frequently on Wall Street it doesn’t have to happen.  As I’ve previously described, markets are highly complex non-linear dynamical systems.  They can’t necessarily be predicted, but that doesn’t mean that black swans aren’t unavoidable.

I recently came across the last monthly update from Ebullio Capital Management.  In case you’re not familiar with them or haven’t heard the story, they just got their faces ripped off.  The letter begins like this:

“February 2010 was the worst month in the history of  the Ebullio Commodity Fund and we regret to report a return of -86.25 pct for the month, which brings our total return for the year to -95.83 pct and to -89.63 pct since inception.”

Did this have to happen?  Did they have to lose 86% in one month?  Definitely not.  But we can all learn from their loss.  Attached are a few tips to help avoid getting your “face ripped off”.

1)  Understand what you’re investing in.   This might seem obvious, but if you’re not 100% certain how an instrument works then avoid it.  Warren Buffett infamously said that he only invests in things he can understand.  He avoided the entire Nasdaq debacle using this simple rule.

2)  Avoid leverage.   With proper allocation you can create plenty of beta within a portfolio without being leveraged up.   Leverage is almost always a recipe for disaster if you are playing with high(er) beta instruments.  My rule: don’t make bets with money that isn’t yours.

3)   Never let more than 20% of your portfolio put 80% of your portfolio at risk.   Risk management, money management, position sizing and true diversification are paramount in any portfolio plan.  If a few positions are determining the majority of your performance then you’re not properly balanced and that means you’re taking more risk than is necessary.