Understanding Six Sigma Events

The chart below is one of the most important charts in finance.

If you are down 10%, you only need to make 11% to recoup your losses. That’s a much easier proposition than having to make 100% following a 50% loss.

Know When to Play Defense

If we reach a -10% drawdown on our portfolio we will immediately start to play defense and ignore all offense propositions. I know that I can easily recoup from a -10% loss. Playing defense means focusing on short-term trading and reducing the size of my positions. It also means reducing the overall leverage used in the portfolio.

Be humble: You don’t know what you don’t know

What can go wrong? Everything.

Most investors base their expectations on what they have experienced in their lifetimes, based on the then prevailing common knowledge. They do not put enough emphasis on risk management and the potential risk for fat tails or six sigma events which can wipe out decades of positive returns.

So, what is a Fat tail or Six Sigma Event?

CONTINUE READING