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Wall Street Billionaire Bets Wrong – Loses BIG

This is the year billionaire hedge fund manager, John Paulson, goes from champion to chump.

Am I being harsh? Perhaps. But that’s beside the point.

What matters is making sure we don’t ignore his unfolding and tragic demise. Instead, we need to sear it into our brains as a stark and valuable reminder. Nobody – not even billionaires – can escape the laws of investing.

Let me explain…

Burned By the Inflation Bogeyman

Talk about going from a zero to a hero on Wall Street!

Few investors knew of John Paulson prior to 2006. But then he shorted the subprime mortgage mess and generated a $15 billion profit for his hedge fund’s investors. And in the process, he became a household name.

Mind you he gained much more than fame. His timely and lopsided bets on the housing collapse minted him a “small” fortune, too. In 2007, he took home an estimated $3.7 billion – arguably the largest one-year payday in Wall Street history. Not too shabby.

Fast forward to 2011, though, and Mr. Paulson’s not going to be so fortunate.

Once again, he’s making an outsized bet. This time on “inflationary” assets – investments that perform best during an inflationary environment.

Specifically, he’s invested 29.6% of his funds in financials, 14.5% in basic materials, and another 8.6% in oil and gas. That’s means that more than half of his entire portfolio is riding on a single prediction – that a nasty bout of inflation is imminent.

The only problem? Mr. Inflation has largely been a no-show.

As a result, Paulson’s flagship fund is down 47% so far this year, according to a report in the Financial Times. Ouch!

And such a poor showing all but ensures that he’s going to struggle for years to come.

The Long Road Back to Breakeven

Please understand I’m not crucifying Paulson for making a bad investment. Heck, we’ve all done it before, even if we don’t readily admit it. (I famously recommended shorting gold back in early 2009. Bad call!)

No, the reason I’m critical of Paulson is because he made such a lopsided bet. As they like to say on Wall Street, “Leverage cuts both ways.” And in this instance, Paulson’s cut is a deep one.

As the table below reveals, just to get back to breakeven, Paulson needs to generate about a 100% return. That’s darn near impossible to do in a short period of time. And it’s completely impossible to do without making yet another lopsided bet and being right.

So how could he have avoided this predicament altogether? It’s simple really…

The Three Keys to Sidestepping Financial Ruin

All Paulson needed to do is asset allocate, position size and use trailing stops.

By spreading investments across multiple asset classes (i.e. – not putting all our eggs in one basket), we make certain that a downturn in a single type of investment can’t sour our entire portfolio.

The same rationale applies for position sizing. By never investing too much of our portfolio in a single investment, we eliminate the risk of a single company or investment sabotaging our net worth.

Paulson clearly didn’t follow this rule. Take his stake in the SPDR Gold Trust (NYSE: GLD), for instance. At roughly $4.5 billion, it’s equal to about 15% of his total portfolio.

As a general rule of thumb, I recommend never putting more than 4% to 5% of your total assets into any single investment.

Lastly, by using trailing stops of 25% to 35%, we limit our downside and make sure a loss never turns into an unacceptable loss. Or more bluntly, trailing stops make sure we’re never in the unenviable position of trying to claw back to breakeven from a loss of 50% (or more).

Add it all up and Paulson’s terrible 2011 performance is much more fundamental than making a bad investment selection or two. He ignored the basic law of investing: That nobody can be right and beat the market all the time.

As Peter Lynch famously said, “All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out.”

That is, as long as you don’t invest too much in those losing bets, which are an inevitable part of the investing game.

Bottom line: It doesn’t matter how rich you are. If you fail to asset allocate, position size and use trailing stops, it’s only a matter of time before you blow up your portfolio.

Ahead of the tape,

Louis Basenese