Want to Avoid Blowing Up Like Paulson? Don't Forget Buffett's 2 Rules

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Includes: GLD, XLF
by: Charles Lewis Sizemore, CFA

It’s been a rough year for John Paulson. According to the Financial Times, Mr. Paulson’s flagship Advantage Plus fund was down 47% for the year (see article). The unleveraged version of the fund — ostensibly more conservative — was down by “only” a third.

I’ll refrain from kicking Mr. Paulson while he’s down. The market gods tend to smite the arrogant, and everyone makes the occasional bad trade. Everyone. Yes, even demigods like Warren Buffett, and we’ll get to him a little later.

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

Take a look at Figure 1. This chart shows the subsequent gains that you’d have to earn in order to recover a given loss. A 10 percent loss requires only an 11 percent gain to get back to break even. A 20 percent loss requires a slightly higher 25 percent to recover.


(Click to enlarge)
Figure 1

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

This is what prompted Warren Buffett to pen his first two rules of investing:

  1. Don’t lose money.
  2. Don’t forget the first rule.

John Paulson broke Mr. Buffett’s two rules by making an enormous bet on an inflationary boom and by failing to ask that all-important question: What if I’m wrong?

Paulson had roughly 30 percent of his fund in financials, 15 percent in materials, and 9 percent in oil and gas. (See John Paulson’s current portfolio holdings here.)

Paulson also happens to be the largest shareholder in the SPDR Gold Trust (NYSEARCA:GLD) 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. It doesn’t matter what “currency” you report on your quarterly statements. Returns are returns. Paulson’s clients who chose to denominate their account in gold took losses every bit as large as those that denominated in dollars.)

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

This isn’t sound portfolio management; it’s gambling

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

Good investors — and good gamblers too, for that matter — practice risk control. 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.

If you want to avoid finding yourself in Mr. Paulson’s predicament, remember Warren Buffett’s two rules.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.