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.
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.
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Cameron Hight, CFA, is an investment industry veteran with experience from both buy and sell-side firms, including CIBC, DLJ, Lehman Brothers and Afton Capital. He is currently the Founder and CEO of Alpha Theory, a risk-adjusted return based Portfolio Management Platform provider.