The Most Important Element in Investment

Research Article:
The Most Important Element in Investment

Section (1): The Question

What is the most important element in investment?

Section (2): Our Research Article’s Answer

Our answer is ‘Capital Preservation’.

Definition: ‘Capital preservation is a investment strategy characterized by a desire to avoid risk of loss.'

Section (3): Support for our answer

The wealthiest investor in the world Warren Buffet says it well:
“Rule No.1: Never lose money.
Rule No.2: Never forget rule No.1”.

George Soros (dubbed "the man who broke the Bank of England.") said:
“Survive first and make money afterwards.”

Gerarld Appel [ inventor of the popular technical indicator Moving Average Convergence-Divergence(MACD) ] said:
“It’s not how much you make that counts; it’s how much you manage not to lose”.

Larry Hite (Called by the daily Business Day an enormously successful investment manager of the 1980s. He is considered one of the top 100 traders of the 20th century.) said:
“If you don’t bet, you can’t win. If you lose all your chips, you can’t bet.”

Mark Tier [Author of “The Winning Investment Habits of Warren Buffet & George Soros” (international bestseller).] wrote:
“Preservation of capital isn’t just the first winning investment habit. It’s the foundation of all the other practices the master investor brings to the investment marketplace, the cornerstone of his entire investment strategy.”

Section (4): The Perils of Drawdown (making losses)

Drawdown refers to the percentage drop in your account size after one losing trade or consecutive losing trades.

For example, after a few losing trades, your $1,000 account is now left with $600; that would be a drawdown of 400/1000= 40%.

After losing 40%, the investor/trader now starts with a lower base, i.e., to undo the $400 loss, the return he needs to generate is 400/600= 60.66%.

The more severe the drawdown, the harder it becomes to undo the damage, as shown in the chart below:

Percentage Loss of Capital (Drawdown)	Required Return on Investment (ROI) to Undo Drawdown
10%	11.1%
20%	25%
30%	42.9%
40%	66.7%
50%	100%
60%	150%
70%	233%
80%	400%
90%	900%
100%	Infinite

Bear in mind that Warren Buffet, whom many people consider to be the world’s top investor, only makes a ROI of around 20%-30% per annum.

Section (5): Does a ‘Capital Preservation strategy’ restrict investors from making high returns?

Consider the traditional belief in the field of finance which states that “the higher the risk, the higher the returns”. If a trader/investor's primary aim is to make explosive profits (high returns) and not mainly to preserve his capital, his portfolio may be exposed to a much higher risk, which in turn increases the probability of his account suffering a drawdown.

Lessons are to be learnt from investors/organizations which do not make preservation of capital their primary aim. For example ‘Lehman Brothers’, ‘Long-Term Capital Management’, and Nick Leeson who singlehandedly incurred billions of dollars in trading losses, resulting in the collapse of Barrings Bank, these organizations went bankrupt because their primary aim is to make big profits at the expense of their underlying capital.

When a trader/investor's first priority is capital preservation he will refrain from trying to make returns from the market by speculations. He is likely to develop the good virtue of patience and discipline and will only buy or sell a new position when he spots what he considers to be a low risk and high probability trade.

Section (6): Tips/strategies to prevent Drawdowns

6.1) Always adhere to a strict money and risk management rule. Make sure that every trade is at most 2% of the
overall capital size. This will ensure that even if the trade turns sour, the losses incurred from that trade will
not create a big drawdown in the portfolio.

6.2) If you are a short term trader and not a long term investor, always set a stop loss whenever
you open a new long or short position. This will prevent you from making a severe loss if you are caught in
the wrong side of a trending market.

6.3) Educate Yourself: Be diligent to acquire the necessary knowledge that is required to make informed
investment decisions. Learn and try to master both fundamental and technical analysis.

Written by:
Liu Weimin
I.T. & Research Director (Academic Year 2009/2010)

~disclaimer:The information, statistical data and opinions contained herein are of the author’s own, and have been obtained from sources which he/she believes to be reliable, but it does not represent that they are accurate or complete, and they should not be relied upon as such. All opinions expressed and data provided herein are subject to change without notice. ALL investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Read any and all prospectuses carefully before making any investment decisions. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment and we are expressly prohibited from guaranteeing accounts against losses arising from market conditions. SIM-INC and its members will not be held liable in any manner for any losses arising directly or indirectly from investment decisions undertaken based on the information/statistical data/opinions expressed.