Capital Protection - Main ideas

Investors and traders often concentrate on potential profits and neglect the importance of protecting investment capital. But it is of paramount importance to understand why it is crucial to protect investment capital in a first place.

In our article, you will discover several key ideas behind capital protection, which should help to improve the chances of success during investment or trading process.

Table of Contents

Key Takeaways

What is Capital Protection?

Why Capital Protection?

Ideas for Protecting Capital

Conclusion

Key Takeaways

• Protecting capital will increase the chances of survival in the markets.
• Percentages are not symmetrical for profit and losses.
• Just one catastrophic result during a particular investment period can destroy the whole set of good investment results in all the other periods.
• Ideas to protect investment capital.

What is Capital Protection?

In this article, we discuss Capital Protection in a sense of not allowing losing a big portion of initial investment capital by ways of explicit or implicit strategies of investment behavior.

Why Capital Protection?

But before we mention potential investment strategies to protect investment capital, we should understand why it is so important to prevent investment capital from falling far from its beginning amount.

1. Percentages are not the same for profits and losses.

We often encounter percentages of changes in various metrics. For example, inflation increased by 3%, or GDP fell by 2%. What is not clear here is that a certain amount of percentage decrease is not equal to the same percentage increase. When something falls 50% in value, it will not require the same 50% of rise to get back, it will require 100% of rise. Say, something was 80. It then falls 50%. It becomes 40. If it subsequently rises 50% (which is 20 = 40 * 50%) it will only reach 60. To reach the original level of 80 from 40, it should rise another 40, which is 100% from 40.

One of the simple illustrations of the reasons to protect investment capital is the below table of percentages of losses and required profits to get back to the initial level of capital:

We can see that as the loss of capital grows the percentage of profit required to get back to the original level becomes more significant and disproportional to the percentage of loss. If investment loses 90% it will require a gain of 900%(!) just to breakeven. And from much lower capital base, which means lower purchasing power. Consistent investment returns of 900% is almost non-existent and difficult to achieve. This is why when a trader or investor allows investment capital to fall below certain level of its original value the chances to get back to the original value become smaller and smaller. Many professional investment managers liquidate their investments when the losses reach 20-25% and return whatever money is left to their investors – they understand if they continue to accumulate losses it will be really hard for them to show overall profitable results to their investors.

To conclude, investors should protect investment capital from losing a significant portion of it to prevent it from falling far enough and eliminate almost any chances of getting back to the original value.

2. Compound growth rate

One of the metrics widely used in investment industry to measure investment performance is the so-called compound growth rate. Usually, it is calculated using returns on the annual or monthly basis, for example, we can speak of Compound Annual Growth Rate, known as CAGR. The metric shows cumulative return on investments compounded over the investment horizon. We are not going to go into details of calculation, but make a note that it is basically what is called geometric average (versus arithmetic average) and uses multiplication of all the returns during the investment horizon. The key here is the word “multiplication”. It implies that all the returns for all the interim periods (monthly, annually, etc.) are multiplied to get a final number. The returns are expressed as fractions of investment values in the current period compared to the previous period. This means that if investment lost certain amount during a particular period the fraction is below 1.0, and if the loss is significant that fraction becomes closer to a very small number. In the extreme, in case of a catastrophic loss it becomes very close to zero. And no matter how good all the other returns are in that multiplication, just one very small number makes the whole result of multiplication such that the overall investment result will be a loss (in the extreme, significant, almost irrecoverable loss).

This is why all the good results can be wiped out by just a single catastrophic loss making all those good results irrelevant. This is just another illustration of the principle of capital protection.

So, why investors should protect their investment capital and prevent large, and especially catastrophic, losses?

Investment process is not a guarantee of profits, and the main idea is to try to keep the value of original investment capital from falling too much to be able to make future investments even if there are unsuccessful outcomes in a particular period. It is a matter of survival.

Ideas for protecting capital

There is not even one solution for capital protection and any particular strategy depends on multiple considerations, such as type of instruments, trading style, specific markets and its characteristics, and other. But we will point out several directions to think about.

• Capital allocation. When implementing a particular trading or investment strategy, investors usually have an idea where the strategy will be likely to fail and calculate worst-case scenario resulting in a maximum projected loss. It is sensible to keep that projected loss as a very low fraction of investment capital. It is difficult to say what fraction is optimal as it depends on various factors, but for example, investor can allocate 1% of investment capital to particular investment idea.
• Stop-loss. There is a notion of “stop-loss” in the trading industry. It relates to the fact that for each trade there is a pre-defined price level, where the trade loses its appeal and position is closed with a loss. This is one of the controls that may help to keep losses contained. It will prevent the losses to become unmanageable resulting in bigger than planned losses. One thing to keep in mind: even if the stop-loss level is established and enforced, there is still a possibility to realize bigger than expected loss due to significant changes in prices without smooth continuous price changes, so called “gaps” – see “Options” below.
• Historical back-testing. It is a good practice to test how a particular idea behaved previously and what was the biggest potential loss in history. This may help to determine optimal size of investment given potential worst-case scenario, although there maybe future precedents surpassing even previous historical extremes.
• Options. These are special types of instruments, which behave similar to insurance. And insurance is one the best ways to protect from unexpected catastrophic events. Used properly options can provide significant benefits to capital protection (including avoidance of “gaps”) but the use of options requires some knowledge and experience. In addition, not all the investment areas offer these instruments so the choice may be limited. Investors are encouraged to look into this area at least in terms of understanding potential use cases.

Conclusion

Protecting capital is an important approach to investment process. The key idea is to preserve the capital to be able to make future investments. A couple of illustrations showed why it is important to protect capital. We presented several potential directions of thinking to protect capital.