Mistake # 1: Discounting the Downside
Rule Number 1: Never lose money. Rule Number
2: Never forget rule number 1. Warren
The Problem: In portfolio construction, downside risk is
more important than potential gain. The issue is that a
majority of firms do not calculate a discreet downside
estimate, but do calculate an upside price target. Investment
research often concentrates its efforts on determining a price
target if a thesis comes to fruition even though downside risk
has a more profound impact on portfolio returns.
For example, assume you have a $1 billion fund. If that fund
is up 50 percent this year and down 50 percent the next, does
that fund still have $1 billion? The answer is no, the fund is
now worth $750 million because of compounding. So when
measuring portfolio impact, preventing drawdowns is
disproportionately more important than creating profits for
maximizing long-term returns. If that is the case, the estimate
of downside loss should be a primary point of focus during the
research process, but it rarely is. Most research focuses on
the upside thesis and the valuation associated with that
To compound the problem, the focus on a single thesis
creates confirmation bias, which is a cognitive bias associated
with the exclusion of information that does not support your
case. As soon as you force yourself to evaluate the downside,
you open up to information that supports the downside case and
end up creating a more complete investment opinion.
The Solution: Every investment idea should have a discrete
downside with supported evidence. The potential downside should
be probability weighted against the potential upside to
calculate a risk-adjusted return. This is not dissimilar from
the way a poker player calculates pot-odds to determine if he
should remain in the hand. Firms that focus on downside create
portfolios with higher long-term returns because capital
preservation allows for enhanced compounding. Use risk-adjusted
return to guide position sizing in creating a portfolio that
maximizes return while minimizing risk.
Funds should foster downside estimation by adopting a
culture that acknowledges that even good ideas can lose money.
If you are offered a bet that pays $100 if a die lands on 1
thru 5 and cost $100 if it lands on 6, would you take the bet?
Assuming $100 does not account for your entire net worth, it is
a great bet with a 67 percent risk-adjusted return. And if the
die is rolled and lands on 6, you still made a good decision
but had a bad outcome. An investment culture that can grow to
understand the difference between decisions and outcomes will
flourish. Calculating downside is an important first step
toward that kind of culture.