Portfolio management
No risk whatsoever of going broke
Here is one of the most famous quotes from Warren Buffett: “The first rule of investment is don’t lose. The second rule of investment is don’t forget the first rule.”
It is also the most misunderstood quote. He apparently said it in a television interview. It’s a catchy idea.
To get our heads around this let’s look at something from another famous investor. Peter Lynch wrote One Up on Wall Street in 1989. At that point he had been in the investment business for twenty years and had been manager of the Fidelity Magellan Fund since 1977. In 1989, the Magellan Fund had one million shareholders and the book jacket says that if you had invested $10,000 in the Magellan Fund when Lynch became manager, ten years late you would have had $190,000. Lynch had extraordinary skill. He also was lucky to be a money manager during an incredibly strong market.
Accept periodic losses
Peter Lynch wrote in 1989: “People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game. If they’ve done the proper homework on H&R Block and bought the stock, and suddenly the government simplifies the tax code (an unlikely prospect, granted) and Block’s business deteriorates, they accept the bad break and start looking for the next stock. They realize the stock market is not pure science, and not like chess, where the superior position always wins. If seven out of ten of my stocks perform as expected, then I’m delighted. If six out of ten of my stocks perform as expected, then I’m thankful. Six out of ten is all it takes to produce and enviable record on Wall Street.” (Lynch, One Up on Wall Street.1989,1990) p61
What Buffett really means –1 in 1,000 chance of permanent loss
The following is from Warren Buffett’s Meeting with University of Maryland MBA Students – November 15, 2013, with notes taken by Professor David Kass:
“Q (16) When managing other people’s money and making mistakes, how do you deal with the responsibility/burden?
WB: I tell them I’m going to make mistakes, but the goal is to do this and this and this. I might make mistakes in order to do this, but I will still probably achieve this goal. I try to operate in a way where I can’t lose significant sums over time. I might not make the most money this way, but I will minimize the risk of permanent loss. If there’s 1 in 1000 chance that an investment decision can threaten permanent loss to other people, I just won’t do it.” Individual investors can also think the same way when managing their own money. (Emphasis added)
It’s all about position sizing
So, here’s what Buffett and Lynch’s advice comes down to: A question we frequently ask ourselves is how much to put into any particular position. Regardless of the odds in your favour you can lose money on any single investment. Over the long haul, with a carefully chosen and well managed portfolio, the law of large numbers plays out and a skilled investor will enjoy profitable investing.
One interesting question is whether investors can learn from gamblers about the optimum size of particular investments in a portfolio. Gamblers are familiar with the Kelly system or as it is sometimes called, the Kelly Criterion.
William Poundstone’s 2005 book Fortune’s Formula, The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street explains: “Professional gamblers, who have to have an advantage, speak of ‘money management.’ This refers to the tricky and all-important issue of how to achieve the greatest profit from a favorable betting opportunity. You can be the world’s greatest poker player, backgammon player, or handicapper, but if you can’t manage your money, you’ll end up broke.” (Poundstone, Fortune’s Formula, The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street 2005) p49
The money and betting management system is also called ‘betting your beliefs.’ The system tells the gambler the optimum amount to wager on each bet. The magic sauce is the use of the geometric mean of the return expectations, as opposed to the arithmetic mean.
The math is calculated by taking the ‘mathematical expectation of winnings’ on each bet, say ten bets in a ten-horse race, multiplying them together and then taking the tenth root of the product. This gives the geometric mean of the ‘expectation of winnings’ of each bet. This has the same logic as the words of Warren Buffett quoted above.
The key insights from the Kelly system for common stock investors are as follows:
1. The optimum strategy is the one that gives the highest compound return over the long haul with no risk whatsoever of going broke.
2. A corollary to not going broke is that no position is ever so large that it imperils the portfolio; this is a significant constraint on concentration.
My own rule
With this in mind I have a hard and fast rule that no position will ever exceed 15% of the portfolio. If one of my companies does well and the stock price take the position to 15%, I will sell it down to 10%, which still gives me good exposure to a really great company.
I am critical of Berkshire Hathaway with its huge position in Apple (AAPL), which makes up something like 50% of Berkshire’s equity holdings. It represents a huge idiosyncratic catastrophic risk and violates the advice Buffett gave to the University of Maryland MBA Students. The problem is that Berkshire is now in so deep it couldn’t easily get out.
Conclusion
When Warren Buffett says: “The first rule of investment is don’t lose. The second rule of investment is don’t forget the first rule”, all he means is to avoid the risk of a permanent loss that might imperil one’s portfolio. As Peter Lynch points out, you can’t invest without losing money in some of your investments as you go along. The trick is that over the long haul you make money from your winners. And of course, the idea is to sell losers and hold onto winners.
+++++++++++++++
You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
+++++++++++++++
Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
+++++++++++++++
You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
+++++++++++++++
There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
If you like this blog, tell your friends about it
And don’t hesitate to provide comments or share on Twitter and Facebook