Baron Rothschild

Let’s play a little game – it’s called “Baron Rothschild,” who once said “I made my fortune by selling too early”  (a comment also made by Bernard Baruch). It’s a lot like various kids’ games where you know something bad will happen but you don’t know when. These include “Musical Chairs,” “Don’t Break the Ice” (where you take turns hammering out little ice blocks hoping that you won’t cause the whole surface to collapse), or “Kerplunk” (where a load of marbles rests on sticks that have to be removed one by one). My impression is that investors are playing this sort of game here.

Suppose that the dealer lays cards down, one after another. Each is an annual market return. At any time, you can call out “Baron Rothschild” and go to a defensive position, or you can gamble and get the market return the dealer shows next. The gain cards read – 15%, 20%, 25% and 30%. If you’re in a defensive position you lag the market by 10% when the market return is a gain, but you get 5% if the market return is a loss.

There is one -20% loss card. Once it appears, the game ends and everyone counts their dough.

It turns out that if the loss comes anytime before the 5th card, you’re almost always ensured to beat or tie the dealer by immediately blurting out “Baron Rothschild” even before the first card is shown. For example,

  • 20%, 20%, 20%, 5% beats 30%, 30%, 30%, -20%.
  • 15%, 15%, 15%, 5% beats 25%, 25%, 25%, -20%.
  • 20%, 10%, 5%, 5% beats 30%, 20%, 15%, -20%.
  • 5%, 5%, 5%, 5% ties 15%, 15%, 15%, -20%.

You can easily prove to yourself that even for a six-year market cycle, you still generally win even if you call out “Baron Rothschild” after year two. Meaning it just doesn’t pay to risk the big loss.

The point of this isn’t that investors should always take a defensive stance – some market conditions are associated with very strong return/risk profiles that warrant substantial exposure to market fluctuations. The point is that the avoidance of significant losses is generally worth accepting even long periods of defensiveness – the mathematics of compounding, large losses have a disproportionate effect on cumulative returns.

Remember that historically, most bear markets have not averaged 20%, but approach 30% or more. A 30% loss takes an 80% gain and turns it into a 26% gain. It’s difficult to recover from such losses.

The avoidance of significant losses is typically worthwhile even if, like Baron Rothschild, one is defensive “too soon.”

[Author unknown]

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