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Our Rule #1 – Risk Management

“The first rule is not to lose. The second rule is not to forget the first rule.” – Warren Buffett

So is it possible to not lose? The quick answer to that is “no.” Everyone is going to lose on an investment at some point. No one is right all the time. However, the difference between a successful investor vs. one that is not is not necessarily how many times you win or lose, but it’s how you handle the losses. The key is cutting losses short while letting your winners run.

Let me show you what I mean. The following table represents the drawdown effect of a portfolio. Drawdown defined is simply the percentage or dollar amount that your portfolio loses (draws down) in given period of time.

In the image below you will see two columns. The one on the left represents the draw down percentage that a portfolio may suffer. On the right is the percentage that an investor must make to get back to break even.

Portfolio Drawdown (% your lose)% Gain required to break even
10%11%
20%25%
30%43%
40%67%
50%100%

As you can see, the last thing that an investor can afford to suffer is a large drawdown in their portfolio. A 10 – 20% loss is hard to overcome but is do-able . . . a 30 – 40% loss is extremely difficult to overcome. While some sort of drawdown is inevitable, the ability to keep it as small as possible is what differentiates winners from losers.

This is where our systematic way for cutting losses short comes in. In any “system” you must have a few criteria that keep things simple enough to keep the emotions at bay while still being black and white as to your entry and exit. Meb Faber in his book “The Ivy Portfolio” sums the criteria up best, they are:

  1. Simple, purely mechanical logic
  2. The same model and parameters for every asset class.
  3. Price-based only.

The Iron Gate Global systematic way for avoid bear markets and large drawdowns applies these three criteria using two different price based moving averages. The images below highlight how this portfolio protection strategy would have done in the last two major bear markets. It shows the exit point on the S&P 500 as well as the re-entry point. For the purposes of this article we won’t get into the re-entry point analysis.

Bear Market #1: S&P 500 1999 – 2003

In the bear market of 1999 – 2003 a portfolio correlated perfectly to the market would have lost -13% using the protection strategy vs. a drawdown of -47%. For someone that is looking to preserve capital this is a major difference.

Bear Market #2: S&P 500 2007 – 2009

A more recent bear market that weighs on the minds of investors is the most recent bear market. Using the protection strategy an investor would have lost – 17% compared to a drawdown of -56%. For people that were near retirement in 2007 – 2008, a loss of -56% would have been catastrophic!

A few important notes about using this indicator . . .

Depending on your stage of life you may not want to utilize this indicator. For someone in their 30’s or 40’s it may be advantageous to just let the investments compound or dollar cost averaging into positions knowing that over time the markets will move higher.

For those that are in or at retirement, you may not have that luxury. A large drawdown would delay retirement or perhaps send someone back to work. It’s for those people that this indicator derives most of its value.

It’s also important to note that when this indicator gives a signal we don’t immediately exit. There is a certain amount of discretion involved as we scale out of certain positions over the course of weeks (depending on the market). The indicator can at times give “false” signals so we have to be careful that we don’t make adjustments that cause more damage than provide value.

In summary, while there is no way to protect against all losses, we at Iron Gate Global do take risk serious. Our historical analysis has taught us that only does this protection strategy avoid large portfolio drawdowns it also helps our clients sleep at night knowing that we’ve got their back.

Our rule #1 is the same as Mr. Buffett’s.

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