A Hard Year for Heroes (Or, an Ode to Staying Power)

If your retirement account is in good shape this year, you are ahead of Wall Street's finest. One of the world's largest hedge funds has nearly been cut in half. John Paulson made billions with a huge bet on the housing bubble. His success attracted a flood of capital. At the peak, Paulson's funds managed a whopping $38 billion.

In 2011, though, John Paulson made another huge bet on economic recovery -- a forecast that never came to pass. His conviction, and the size of his bets, turned against him with a vengeance in 2011. At the end of September, Reuters reports, Paulson's largest fund was down 47%. (His other funds are down double digits too, in varying amounts.)

Salida Capital, a Toronto-based hedge fund with a focus on energy and gold, was also cut in half as of September's end (down 49.4%). Three-quarters of that decline came in a single month. Salida had extreme exposure to gold and gold stocks (as did Paulson), and the two-edged sword of leverage cuts deep.

It isn't just those two, though. Many big-name investors are taking lumps in 2011, Institutional Investor magazine reports. Mark Mobius of Templeton Emerging Markets -- down 22%. Bill Ackman of Pershing Square -- down 17%. Value investor Whitney Tilson of T2 Partners -- down 29%. (All these numbers are on an end-of-September basis.)

"Where's the hedging?" jokes Institutional Investor.

A dirty secret of the managed money industry is that, while some funds actually do "hedge" (i.e. take pains to guard against large losses), many of them do not. Given this reality, it might make sense to call them "levered funds" instead.

For investors, it might be useful to distinguish between funds that truly guard against loss, and those whose idea of risk control is "picking the best stocks" or simply "being right." One could further say there is a style of investing -- call it hero investing -- where the manager bets the farm on a very specific worldview. If that worldview comes to pass, and does so in the right time frame, the result is champagne and roses. But if things turn out other than expected, the results can be awful.

It's been a hard year for heroes. Those making big wagers on economic recovery have seen their investment portfolios battered by top-down macroeconomic shocks. And those expecting full-on collapse have been repeatedly thwarted by last-minute hope jags. ("Stocks rise on Europe optimism," a recent headline read. "Stocks rise on same old B.S.," it should have said, "likely soon to jag down again.")

Are there any useful lessons here? Yes. The first one being, "Don't be a hero -- except in very selective circumstances." For example: Many who make the long-term gold and silver case advise avoiding too much leverage... or at the very least, keeping it on a tight leash. For most investors, leverage is like dynamite. A little bit goes a long way, and skillful handling is required. Too much leverage, like too much dynamite, is an invitation for blowing up.

The inverse of leverage is staying power. It is very hard to lose a third of your money in a month (as Salida did) if you are focused on staying power. A key aspect of winning the game is making sure you play for a long time -- that you are never carried out.

There are traders and investors who understand this, and hedge funds that understand it too. They maintain staying power by considering the risk first, keeping leverage in check and focusing on asymmetric bets. (This is exactly the kind of thing my colleague Zach Scheidt does, for instance, in Hedge Fund Strategist.)

An asymmetric bet is one in which the downside is low, or limited, but the potential gain is attractive. Trading strategy examples for limiting risk include cutting losses quickly or structuring trades with options, such that the potential gain is many multiples of the potential loss. Investing strategy examples include a deep value focus, purchasing assets for less than their true worth, and emphasizing staying power (not using too much leverage) so as not to be shaken out.

More than ever, 2011 has proven itself a year for focusing on risk. Fortunately this is a specialty of Insiders Strategy Group, with multiple tools available for limiting downside and maximizing upside.