According to a famous Warren Buffett quote, “Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. one.” And according to me, “Rule No. 3 is never mistake cute folklore for stock-market reality.” Assuming we agree on Rule No. 3, let’s tackle the real question: How much can protect ourselves against big losses without pretty much forfeiting an opportunity to earn reasonable equity returns?

Getting Real About Losing Money

Rule No.1 and Rule No. 2 sound so macho, and so much cooler than reality. Sadly, we live in the real world, where if you have equity exposure, you cannot eliminate the risk of losses (unless you invent a time machine that lets you zip ahead, check stock future prices, and then return to the present without losing your notes along the way.

Stocks go up. Stocks go down. We make money. We lose money. The idea is that netting it all out, we can come out far ahead by being invested, as has worked out in the past for those with reasonable time frames. There has been and will likely continue to be an upward bias in the big-picture equity trend based on growing population, improving education and health care, growing economic activity, rising profits resulting from ownership of productive assets, and in the end, rising stock prices.

But being that the equity market is, in essence, a free market in which prices are set by supply and demand rather than administrative fiat, we have to assume short and intermediate downward moves as economies continually adjust, leading profits to continually adjust, not to mention the countless ebbs and flows of ongoing business and investment-community sentiment.

So how big is too big?

True or false: A loss of 50% is too big, way too big.

OK, I’m sure you knew that was a trick question. Let’s try this:

What’s worse: (a) a temporary paper loss of 70% that by the time you sell winds up a 5% gain, or (b) a realized (permanent) loss of 10%?

Advocates of minimizing Maximum Draw Down (Max DD, the statistic that measures peak-to- trough declines) probably answer (a) as a matter of reflex. And I get it; you don’t know it’s temporary at the time. When you see it in your portfolio, you have no way of knowing it’s only temporary.