# Rule No 1: never lose money. Rule No 2: never forget rule No 1.

### Why its important to protect your downside

Letâ€™s start with a thought experiment. You are planning to make a long-term investment *(10 years)* and you have three options.

Portfolio A grows 10% every year consistently but the catch is that once every ten years, it goes through a 50% drawdown. Portfolio B works exactly the same but only returns 5% and has a relatively lower drawdown of 20%. Finally, you have the option of parking your funds in a 10-year term deposit offering 2.5% APY.

The trick here is that most of us tend to allocate more importance to the returns generated by our investments than to their possible downsides. Simple math shows us that a loss of 10 percent necessitates an 11 percent gain to recover. Increase that loss to 25 percent and it takes a 33 percent gain to get back to break even. A **50 percent** loss requires a **100 percent **gain to get back to where the investment value started. This is why conserving your portfolio is more important than trying for maximum returns.

Coming back to our experiment, portfolio A starts off the strongest generating a yearly 10% return. Portfolio B also outperforms C with a 5% CAGR compared to the pitiful 2.5% return offered by the Term Deposit. But where it gets interesting is once you factor in the drawdown.

After 9 up years and 1 down year*, *portfolio A would have generated an 18% return (*CAGR 1.24%), *whereas portfolio B would have generated a 24% return (*CAGR 2.18%)*. But, both of these portfolios would have been beaten by the term deposit offering a CAGR of 2.5% with zero volatility. *(In this case, we have assumed the drawdown at year 5. The year in which the drawdown occurs does not matter for the overall return).*

If you found this interesting, check out the case for strategic mediocrity.