If you want to stay in the game, never lose big.
Since the original Dow Theory “sell signal” of September 2001, my firm’s strategy has been to manage the risk by not letting anything go more that 15% to 20% against us. This is the philosophy of no less formidable an investor than Warren Buffett.
Buffett says it wasn’t his best ideas that gave him his tremendous track record; it was having fewer bad ideas that resulted in a permanent loss of capital: “We haven’t taken 2 steps forward and one step back. We’ve taken 2 steps forward and a fraction of a step back. Avoiding the catastrophes is really important.”
Avoiding, and/or managing for, the catastrophes is one of the biggest secrets on Wall Street. Anyone in the real world, however, knows that you have to manage for the risks: Apple producers know they’re going to lose 5 or 6 apples out of every 100 to spoilage, and they manage for it. Light bulb manufacturers know they’ll lose 2 or 3 light bulbs out of every 100 to breakage, and they manage for it.
Still, in the investment business, there are very few of us that continually discuss managing the risk. Even some of the best operators on Wall Street have recently failed to adhere to this most basic rule of investing.
Indeed, for years we have idolized Ken Heebner of CGM Focus Fund (CGMFX) fame, as well as Marty Whitman, captain of the Third Avenue Value Fund (TAVFX). Both of these brilliant investors’ track records are legendary – but this year, both of them are down over 45%.
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