Mistake # 1: Discounting the Downside

“Rule Number 1: Never lose money. Rule Number 2: Never forget rule number 1.” – Warren Buffett

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 thesis. ....

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