Capital preservation before profit
Anyone who loses their money has nothing left to win the loss back with. That's why before any question about returns comes the question of how you make sure you stay in the game.
Learning objective: After this lesson you can explain why preserving your capital matters more than the highest return.
Most beginners ask: how much can I earn? People who've been around for a long time ask differently: how do I make sure I can still play next year?
Why Total Loss Matters
The reason is simple. A twenty percent return is no use if you've lost everything before. Zero times anything is still zero. There's no way back from a total loss.
Large Losses Short of Total Loss
Big losses short of total loss weigh heavily too. If Nils loses 40 percent in one year, a good year of plus 40 percent isn't enough to make it up. €10,000 becomes €6,000, and plus 40 percent turns that into only €8,400. He needs about 67 percent to get back to €10,000.
The First Rule
That's why the first rule of every serious strategy is: don't get knocked out. Everything in this level serves that one purpose. No single mistake may throw you out of the game. No position so big that its failure costs everything. No leverage that empties the account on a normal day's move. No bet you can't afford to lose.
The reason lies in returns multiplying. At the end, your wealth is the product of all yearly results, not their sum. If one factor is zero, the whole product is zero, however good the other years were. Experts call a state like that, from which there's no way back, an absorbing state.
Average Versus Single Path
An important difference follows. The expected value describes what comes out on average if a great many people make the same bet at the same time. But you only live one life and make your bets one after another. A strategy can make a profit on average across many people and still ruin you for certain over time if it leads to total loss often enough. An example: a coin toss bet where heads wins you 50 percent and tails loses you 40 percent. On average you gain 5 percent per toss. But if you keep tossing with all your money, your wealth shrinks, because 1.5 times 0.6 is only 0.9.
Ruin Before Return
In practice that means the question of how likely ruin is comes before the question of expected return. A strategy with slightly lower expectations that rules out ruin beats, in the long run, one with higher expectations that could catch you at some point. It's the same idea that justified insuring the big risks in life in level 0.
Summary
- Returns multiply, a single factor of zero makes everything zero.
- A positive expected value doesn't protect you from losing for certain over time.
- No single mistake may throw you out of the game.
Did you get it?
Why can't a total loss be made up with high returns?
Because returns multiply. A factor of zero makes the whole product zero.
What is an absorbing state?
A state from which there's no way back, here the total loss.
Can a strategy with a positive expected value ruin you for certain?
Yes, if over time it leads to total loss or very deep losses often enough.
Check your understanding
Your task
Your portfolio holds $20,000 and falls by 30 percent. Calculate the new value, then how many percent gain you need to get back to $20,000. Check your result in the drawdown calculator and try a loss of 50 percent there.
Sources and further reading
- Physicist Ole Peters (Ergodicity Economics, London Mathematical Laboratory) uses multiplicative wealth dynamics to show why total loss is an irreversible state, and why avoiding ruin over an individual's own time matters more than maximizing expected value across an ensemble. View source ↗
Related
- Win rate and expected valueStage 3
- The classic beginner mistakesStage 1
- Risk-reward ratioStage 3
- Matching questions for this stageQuestions