[MUSIC] Learning Outcomes. After finishing this video, you will be able to define permanent loss of capital, understand when to use permanent loss of capital. We have enough background to move into the nuances of investments, and particularly I want to get into some nuances about risk. All most important propositions of modern finance put against the notion of risk and return. We take as invaluable the action that higher returns are accompanied by higher risk, and vice versa. And that risk and return cannot be decoupled. But things may not be as straightforward as that. Fund managers, of course, are running off of the Holy Grail, trying to generate pure alpha, superior risk adjusted returns that stem from expert asset and security selection market timing. Then, madly pursue assets whose movements are uncorrelated to each other so as to keep to a minimum. These are useful and extremely important for short horizon investors. However, they have a flaw. And sometimes what happens is asset correlations change over time and change in different environments. So all this is important for short horizon investors. But long horizon investors may, in fact, have a different view of risk, a view of risk that's not so dependent on standard deviation. So I want to introduce you to another perspective, another concept to look at. This concept of risk is well conceptualized by the phrase permanent loss of capital. Now, volatility is easily quantifiable and hence is often used as a proxy for risk. But volatility itself has different definitions. What is termed as one-day volatility can be markedly different from one-week volatility or one-month volatility or one-year volatility or ten year volatility. So there's a time dimension even to volatility measurements. So this notion of time horizon is an extremely important idea. Volatility as defined by a movement in prices can come in many shades. One issue is that of mean diversion. Short foreign fluctuations can be smoothed out over longer time periods. Particularly in mean reverting time series. Consider the following daily price changes of the S&P500 over different time horizons. The plot above shows percentage changes in daily prices of the S&P500 from March 1950 to April 2016. 16, 700 days. As we can see, the main percentage change in daily prices is almost zero. And even though the S&P was at 16 in 1950 and over 2,000 today, the daily movements seem pretty static. The plots below show percentage changes in daily prices in 6 randomly chosen, 30 day samples for the same data set. A long-term investor would not be bothered about these short-term fluctuations. As he knows, these variations ultimately revert to long-term intrinsic value. In creating risk to these short term prices, these short term movements may not be appropriate as it is nearly quotational loss. But since long term investor does not plan to change his portfolio, there is no longer an economic loss associated with it. He is more concerned about the second type of price movement, One which does not allow him to recover his capital in case of an adverse shock. What do we mean by this? Permanent loss of capital occurs when volatility or economic events, kill the way your money gets compounded over the long term. Consider an investment of a $1,000 over a 10-year time period, and that compounds annually at 10%, which has been the rate of the S&P over a century. After 10 years, the final value of the corpus would be $2,400. If there's an adverse shock to the portfolio, that leads to a 50% decline in year 6. Then, the corpus at the end of the year 10 would be just $1,000. This investor would just about recover his capital at the end of his investment horizon. And assuming no further shocks, it would take him another 9 years to get to the $2,400 number. If this was a firm he'd invested in, Where would his investment lie? If the firm goes bankrupt or if it's earnings power is permanently impaired. The answer is obvious. In a firm, you'd have probably lost his money. This is the view of risk propounded by value investors in the mold of Ben Graham and Warren Buffett. The risk of permanent loss of capital. Adverse shocks can lead to permanent loss of capital in yet another way. The fire sale of stocks at rock-bottom prices at the wrong period of time. Permanent loss of capital can be avoided if one chooses to invest in indices or in businesses that have the following characteristics. Low-leverage, Consistently high free cash flows, strong financials, and wide moats from competitive threats. In the short run, drawdowns are inevitable and essentially notional unless the holdings are sold. At which point, if this occurs, losses are locked. But healthy businesses such as the ones we just mentioned Prices are likely to bounce back. As a canonical example, take Berkshire Hathaway. A company controlled by Warren Buffet. Since he took over, the stock price has suffered many price drops. In the late 90s, in the financial crisis, 2011 and even last year. But the stock has bounced back repeatedly and the overall trend has been consistently upward. It has had 3 drawdowns of 50% from peak to trough, since Mr. Buffet took control of the account. But the declines in quarter price had no effect on him, since he viewed these declines as merely quotational loss and not permanent loss of capital. This is the key idea behind the idea of permanent loss of capital, are drawdowns due to temporary price movements, or to permanent impairments, either in the business, or in the country, or in the underlying characteristics that make up that investment. People who have long time horizons may have a different view risk, a view of risk different from quotational movements. And many of the great investors have this concept of risk as permanent loss of capital. There's a rule of thumb that sort of says that, in the long run the market is a weighing machine. In the short run, it's a voting machine. The rule of thumb sort of says that it takes three of more years for the weighing characteristics of a market to be apparent over the voting characteristics. As an example, to give a sense of how long you need to consider times for weighing characters, come and look at the S&P 500 since 1962. 3 year returns on the S&P 500 are negative nearly 30% of the time. One needs to be invested in the S&P 500 for 12 years to almost always get historical returns from the past Before I conclude, I need to reiterate one important point. Discussing risk in the absence of a time horizon is meaningless. Investor's time horizon is absolutely essential to understanding his or her capacity to handle risk. If you need to access all your money quickly and how they avail low time risk tolerance and the prospect of the short term coded price decline is your definition of risk. Of your time horizon is long, your view of risk is more nuanced. You should measure risk, as a decline in unit price, measured over a long period of time. And by that definition, permanent loss of capital may be your definition. Many long term investors, value investors, and private equity in particular, because after all, private equity doesn't have a market to markets like in public markets. They view risk through the lens of permanent loss of capital. Many endowments and sovereign wealth funds use this mindset to argue, that their big advantage over other investors, is the ability to withstand market to market fluctuations, because their view of risk is a permanent loss of capital, and they can tolerate short term fluctuation. [MUSIC]
