In Case You Forgot Rule Number One

There is a famous quote by investment guru Warren Buffet, "Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1." 

But why is this rule so important?

The reason has to do with what we call “Asymmetry of Gains and Losses”.

Basically, if you suffer a 10% loss, say your $1000 investment falls to $900, you have to earn 11% just to get back to $1000. In the financial crisis of 2008 many investors experienced a loss of 50%. This meant that they had to get a 100% return just to break even.

Source:   Empire Life

I’d like to put this into the perspective of active versus passively managed money.

One of the common complaints of those in actively managed funds is that their portfolios are not beating the market. What are we paying them for if they can’t bet an index right? In fact, most actively managed funds will return 80% to 90% of what the market performs. In other words, if the market is up 10%, your actively managed fund would be up 8% – 9%. This has been one of the factors driving money into passively managed products over the last 9 years. Because passively managed funds will often have performance much closer to the underlying index in up markets.

But the value in actively managed funds is not in outperforming the market in up markets, its in out performing the market in downturns. You want to invest in actively managed funds for the downside protection.

As an example, an actively managed fund may capture only 60% of a down turn. This means if an index loses 10% in a given year, an actively managed fund may only be down 6%. Where as an index fund might drop 10.5% (the index return plus fees). In reality the loss may be deeper because of the nature of their requirement to sell indiscriminately. See article It's Gonna Be Worse.

In summary, we see that when we lose money, we have to get a return much higher than the loss % just to break even. That’s why we want to be in a portfolio with an emphasis on capital preservation – not losing money. But markets will go down from time to time, and only actively managed funds can mitigate the loss through there downside protection.

For more information on the impact of passively managed money on markets and investment returns read The Case For Active management, The Upcoming Market Crash, Are you swimming naked?, It's Gonna Be Worse, Is This Your Doctor?, & You're Behaving Badly.

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