1. Avoid Large Drawdowns
Avoid large drawdowns is the same as Warren Buffett’s famous rules:
Rule No. 1: Never Lose Money
Rule No. 2: Never Forget Rule #1
Sometimes rules seem so simple some investors have a tendency to blow it off. However there is a profound reason that Buffett and other successful investors make this priority #1.
Drawdowns cause exponentially greater damage the larger the drawdown. In other words:
It takes an 11% gain to recover a 10% loss. Not a problem.
It takes a 25% gain to recover a 20% loss. Harder.
It takes a 43% gain to recover a 30% loss. Problem.
It takes a 67% gain to recover a 40% loss. Big problem.
It takes a 100% gain to recover a 50% loss. Devastating.
It takes a 300% gain to recover a 75% loss. Catastrophic.
The best approach to make money in the long term is not losing it in the short term.
2. Implement an Adaptive Asset Allocation
Studies show that close to 90% of investment returns are determined by portfolio asset allocation. Yet most investment information focuses on choosing individual investments.
Don’t get me wrong. I spend a great deal of time looking for individual undervalued investment opportunities. Finding individual investments with a margin of safety is an important aspect of value investing. However, choosing your asset allocation is more important and therefore deserves your serious attention.
Simply stated, investment allocation is how you divide your assets between different investment classes or groups. An adaptive asset allocation provides the investor a dynamic investment allocation strategy that adjusts to favorable and unfavorable valuations. Instead of a strict fixed percentage you have greater flexibility because you can choose from a range based on valuation levels.
Different valuation levels should require a different investment allocation of your capital. One of the most important concepts in investing is to be careful or prudent about the price you pay. It’s not possible to do this without changing your allocation to asset categories after they make large price swings.
The value oriented investor would want to allocate more to assets that were priced the farthest below their real or intrinsic value. Assets that are priced above their real worth can be completely avoided or minimized.
Consider your investment allocation during the first decade of this century. Should your portfolio have held the same percentage of equities when valuations were sky high (i.e. 2000) compared to after they fell 57% in 2008-09? Of course not.
We live in the best era in history for investing. Competition has reduced transaction costs on individual investments and produced new investment vehicles (i.e ETFs). This allows investors to move from overvalued assets to undervalued assets with relative ease. It no longer makes sense to maintain positions in grossly overvalued assets.
An adaptive investment allocation is an effective means to limit your portfolio risk. During time periods when investment assets are overvalued an adaptive allocation allows an investor to “hide” in cash. Cash can help protect your portfolio in bear markets. You cannot buy low and sell high by allocating money to assets that are expensive.
At the same time, having cash available when market valuations are low provides investors the ability to take advantage of favorable opportunities. Think about how much better you would do if you bought more when prices are low and less when prices were unfavorable. Many investors do just the opposite and wonder why their long term returns suffer.
3. Require a Margin of Safety
Require a margin of safety for each individual investment. Margin of safety in an investment is the difference between the fundamental or intrinsic value and the price of your investment. “Price is what you pay. Value is what you get.” (Warren Buffett)
The larger the margin of safety the less risk you assume, the greater your potential capital gains, and the higher your income percentage (i.e. dividend or rent). A margin of safety leaves room for judgement errors, mistakes, of unforeseen adverse conditions.