Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. – Warren Buffett

If a $100 million dollar fund is up 50% one year and down 50% the next, do you still have a $100 million dollar fund? No, the fund has been reduced to $75 million or a 25% loss. I use this question in almost every conversation with an investment manager to highlight the importance of downside.

And the order of the sequence doesn’t matter. We could have lost 50% first and then gained 50% and the ultimate result would be identical. So, why does loss have a disproportionate impact? This simple illustration highlights the asymmetry of returns in compounding portfolios. This means that returns come in sequence not simultaneously. So any loss creates a smaller bankroll with which to make subsequent bets. Gains on the other hand, although they do increase your bet potential, lack the impact of a commensurate amount of loss (this is why the Kelly Criterion makes sense). The reason is simple. In our original example, the $50 million gain from a 50% profit is only 33% of the overall $150 million in the fund. But, the $75 million loss associated with going down 50% represents a full 50% of the $150 million fund total. The 25% loss associated with this example is the empirical proof of Buffett’s very famous quote that served as the prelude to this article.

So if loss and gain are not created equal, then what is more important to define in portfolio construction? How much you can make or lose? Clearly, understanding loss is the foundation of all sound portfolio management. Just ask any manager fighting to get back to their high-water mark (a manager down 25% in ’08 has to have returns of 33% to get back to pre-2008 levels).

The message is short and sweet. Spend the time to estimate an explicit downside before an asset is allowed into the portfolio because downside risk is the true swing factor in portfolio management. Additionally, if a firm only calculates a single value based on the thesis coming to fruition there is an implicit assumption of a 100% probability of that thesis coming true. Finally, mandating a discrete downside calculation allows the research team to expand their investment mind and encourages the search for the devil’s advocate. This subtle shift moves a firm away from a process where the focus is typically finding evidence to support their thesis (http://en.wikipedia.org/wiki/Confirmation_bias) to a process that searches for complete information.

I’ve had hundreds of conversations with fund managers, analysts, traders, etc. about the warts of their investment process. And, as simple as it is, if given the ability to make only one change inside of a fund, calculating a downside would be it (try out our calculator to measure the impact of downside).