ALBERT HERTER

”’UP 40%, BUT STILL FEELING DOWN,’ from the Sunday N.Y. Times. IMPORTANT READ. Why it is so important NOT TO LOSE MONEY! Warren Buffet’s first rule of investing!

In Uncategorized on July 27, 2009 at 02:27

While we are not satisfied with our performance in the last quarter, we are happy to report that we didn’t lose as much money as the average stock mutual fund.

That wouldn’t be a very sexy sales pitch: mutual fund managers don’t typically phrase their shareholder letters quite that bluntly.

But the truth is that for most investors, it’s more important to avoid big losses than to rack up big gains. That may seem a milquetoast approach, but in the miserable market of 2008 and early 2009, minimizing losses was the best that most people could do. And because of the ugly math of investing, it has been extraordinarily difficult to recover from big declines.

“People often don’t understand why they are still in a deep hole, even after they’ve had a year of great returns,” said John Bogle, the founder of Vanguard and the creator of the first index mutual fund. It is because when your portfolio shrinks substantially, you need an enormous gain, in percentage terms, to climb back to where you started. This is part of what Mr. Bogle (citing Justice Louis Brandeis) calls “the relentless rules of humble arithmetic.”

Here’s how the math works:

Suppose you lost 40 percent in 2008 — roughly the decline in the Standard & Poor’s 500-stock index. One dollar at the start of the year would have been worth 60 cents at the end. Then say that after that loss, you posted a gain of 40 percent (the rough increase in the S.& P. 500 from its March low through the middle of July). That’s a spectacular return.

Time to celebrate? Not really.

A 40 percent gain on 60 cents is 24 cents. Your original $1 is now only 84 cents — you’re still down 16 cents.

Mr. Bogle did some calculations based on the assumption that you invested $1 in the S.& P. 500 at its peak. By March this year, the index had dropped 57 percent, reducing your dollar to a mere 43 cents. After a 40 percent gain, your little stash was worth only 60 cents. Even worse, he said, is the “exponential factor” in losses and recoveries. If your initial investment fell 50 percent, you would need a 100 percent gain to return to the starting line. If you lost 75 percent, you would need 300 percent.

Although stocks tend to outperform bonds over the long haul, gains that big are hard to come by. And that, in a nutshell, is why it’s better to avoid big losses in the first place.

Hersh Cohen, chief investment officer of ClearBridge Advisors, a Legg Mason subsidiary, says he believes in this philosophy wholeheartedly. “Make sure you don’t get killed on the downside,” he said. That’s more important, he said, than “worrying about the upside.”

Mr. Cohen has managed the Legg Mason Partners Appreciation fund for 30 years, over which he has beaten the S.& P. 500, according to Morningstar. The fund has returned 11.9 percent annualized, compared with 10.9 percent for the index and 10.4 percent for the average large-capitalization stock fund. (For the last 14 years, he has co-managed the fund with Scott Glasser.)

Last year was “the worst in my career in 40 years of managing funds,” Mr. Cohen said. Partners Appreciation lost 29 percent, and he said he “went home depressed about it every night.” Still, that performance was much better than the overall market and a vast majority of stock mutual funds.

MR. COHEN focuses on companies with “superior balance sheets” and rising dividends. At the moment, in his estimation, those include Wal-Mart, Travelers, Johnson & JohnsonCisco Systems and Berkshire Hathaway.

Mr. Cohen holds a doctorate in psychology — a background he calls most helpful in “market extremes.” He says he tries “to act on extremes — but to act the other way,” cutting back when the market is euphoric, and increasing his bets when others panic “and stuff is being given away.”

For his part, Mr. Bogle has reduced the risk of big losses by diversifying most of his own portfolio into safer fixed-income holdings — 80 percent of it — which, he said, is appropriate for his age. He is 80 and holds index funds, and while he remains bullish for the long term, he said that by being cautious he has enjoyed a “consistently good night’s sleep over the last few years.”

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