"Rule #1- Never Lose Money
Rule #2- Never Forget Rule #1"
Warren Buffet

Since referring to the wisdom of the world's greatest investor seems to be a common theme this week, I wanted to highlight again some of my own rules that I have developed/(borrowed?) by following his annual shareholder letters. These simple rules might help to explain why my Strategy Lab Portfolio looks so much different from everyone else's...

First, I wanted to highlight an important factor for anyone who invests heavily into mutual funds. In my opinion the true investment talent could only be separated from luck in a period of bear market turbulence. During the go-go years of the roaring 90s it became too simple to claim that one manager is great at stock picking, just because his/her portfolio has done well during the period of widespread bull rally. In the end many of these funds have ceased to exist during the 2001-2002 bear market... From what we are seeing so far, a similar chain of events is unfolding today. Most of the former star "financial sector heavy" mutual and hedge funds have suffered blows that forced them to either halt redemptions or even led to outright closures. This pain could be avoided...

History of outperformance in the rough market should become one of the most important factors in any investor's decision when deciding into which mutual funds to invest. Next time instead of relying purely on the conventional Morningstar rating system, spend an extra few minutes and study the fund's performance during the last bear market-if you see heavy losses which were only made up later in the "go-go" bull times- my advice is- run for exits while and if you still can...

As the wisdom of the world's most famous investor states, the first objective of any investment manager should be to make sure he/she does not lose clients money-period. Swinging for the fences to achieve 40%+ returns could be a great strategy for winning a short term investment contest ,or earning a quick bonus if you working at the most prestigious legalized gambling area in the United States called Wall Street. But it could also quickly become a major pain for the unexpecting retail investor.

As I have stated before, I personally am an opinionated active value investor, who likes to disagree with the general public's opinion. I do tend to trade in and out of my losing positions much faster than a typical fundamental Buffet admirer. But explanation for this difference, in my mind, is very simple- even if you utilize all of the well known Buffet valuation principles (like focus on free cash flow, low multiples etc) when picking your own investments- let's be realistic- you can't possibly emulate his strategy perfectly.

You simply don't have the virtually unlimited resources, ability to talk/interview any executive in the country or ample liquidity to ride out any personal downturn. In addition, your time horizon is likely to be much shorter than that of Buffet- simply because he does not have to sell any of his holdings to pay the medical bills, kid's tuition or deal with unexpected medical emergency. So if you take any one of these factors from the complete "Buffet investment equation" - your results are likely to be much different than his and not to the positive side...

Anyway, back to the original point- here are some the risk management rules I follow to try to reduce the pain during the flat or down market:

1. Never have your money invested in one sector because your probability of losing a lot of money quickly increases drastically. It really does not matter how much you think the sector is undervalued relative to the overall market- sector bets are dangerous- period!

2. Don't be afraid to switch your stance towards a specific stock or a sector if the facts (like unexplainable severe declines...) tell you to do so. "Flip flopping" might bad if you are running for president but it is a necessary skill if you want to succeed in investing. Remember, that unless you have developed a disciplined way to deal with money losing positions, one day you are likely will have your gains wiped out completely or severely reduced by a prolonged bear market- a good example would be shareholders of BSC, MGI or FMD...

3. Even if you are a contrarian investor, and thus like to average down on stocks that are going through a period of a serious correction, at least don't take a full position to start. On my contrarian bet I usually begin with roughly 1/3 of my mental maximum position. Remember, you have to leave yourself some room for errors, as you are certain to make quite a few of them. Markets do overreact all the time but they also tend to be right over the long haul- so don't be too stubborn...

4. Don't invest more than 15% of your money in any one stock regardless of how cheap you think it might be (that includes positions were you averaged down several times as well)

5. Don't argue with the Fed in the short term- (like going a 100% short of gold/commodity related stocks when Fed keeps irrationally cutting rates...) I don't care how passionate you are about it and how wrong do you think the Fed is- don't forget Fed controls the dollar printing press and thus could win any short term battle by default

6. Don't listen to fools who tell you that you can time the market- your chances to do that consistently are not much higher than winning a lottery. Stay fully invested- if you aren't feeling good about the market and don't use short sales-hedge with lower beta stocks or short sells to reduce the overall sensitivity of your portfolio.

7. The smartest thing you could do to reduce the overall volatility/risk of your portfolio is by not being afraid to use short sales. It is not easy, and does require a whole different approach than pure "long only" investing but, if used correctly, could pay major dividends for you over the long haul. ( Vad's short selling rules)

6. Also, don't be afraid to disagree with everyone with anyone (except the Fed ) - but if you do go against the crowd (like shorting fertilizer, Chinese or dry shipper stocks when everyone is buying... )-make sure you have enough liquidity to stay solvent, if they (general public) turn out to be right for a prolonged period of time...

Stay safe and please feel free to send me your comments at skepticalcapitalist@gmail.com
Vad