The Yellowstone Factor: Minimizing Downside Risk

Minimizing downside risk is the first step toward being a successful investor. As Warren Buffett succinctly puts it:

Rule No. 1: Never lose money.
Rule No. 2: Never forget Rule No. 1.

You always need to be cognizant of six sigma events that can have an ugly impact on your portfolio and account for the approximate probabilities. Whenever I look at any investment opportunity, I first fixate on what factors can cause the investment to result in a significant permanent loss of capital. Besides Yellowstone, there are the usual suspects: wars, terrorism, fraudulent financial statements, dishonest management, disruptive innovation, etc. But how can you figure out the probabilities for each one?

Fat Accounting

As a child, I remember my mom periodically working out our monthly household budget, which usually took her no more than five minutes. As I entered my teen years, I took a closer look at her process and complained that she'd lumped things into just a few broad categories -- with a healthy dose of rounding up of each line item. I told her that the correct way to do it would be to expand the individual line items and put down more precise numbers. Needless to say, my mother has never changed her ways. All she'd do was smile and say in Hindi, "Yeh mota hisaab hai" -- translated as "This is quick-and-dirty, back-of-the-envelope accounting."

Investing is not a discipline based on absolutes or precise mathematics. There simply aren't enough data points available to work out the exact odds. It is an exercise in working out the "mota hisaab" probabilities.

It has been years since I've used a spreadsheet to assist in an investment decision. If I find myself yearning to run some calculations in Excel, it serves as a mental red flag to drop the investment from consideration. Excel is not helpful in figuring the exact odds of Yellowstone happening in the next five years. However, if I ascribed odds of less than 1% to Yellowstone blowing in the next 10 years, I'm covered.

---

Mohnish Pabrai is the managing partner of Pabrai Investment Funds, an Illinois-based value-centric group of investment funds. At time of publication, Pabrai held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He appreciates your feedback at [e-mail]. You can access his Web site at www.pabraifunds.com.

TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.