Alpha Theory Best Practices (Part Three)

This is a continuation from our previous post (Alpha Theory Best Practices (Part Two)).
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Best Practice #3: PROTECT THE DOWNSIDE
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“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” – Warren Buffett

In my previous Best Practice post, Best Practice #2: CULTURE OF THE DEVIL’S ADVOCATE, I highlight the importance of encouraging a culture that questions the primary thesis of an investment idea and brings out the downside risk. One of the recommendations was a required explicit downside estimate as part of every investment recommendation. This seems reasonable, but its importance should not be overlooked. In fact, the downside is even more important than the upside. Here’s why…
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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.

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. The downside risk target should be supported by a narrative just like the reward target and be sure to include the impact on the capital structure when downside scenarios play out (i.e. the company is a net-casher and has lots of wiggle room or the company is a net-debtor and the leverage that benefits the upside is just as dramatic on the downside and potentially more because of covenants and refinancing.)

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 an explicit downside would be it.