Return on Capital vs. Return of Capital

When most traders get started they come into the market with one thing on their mind; make money fast! Return on capital becomes more important than return of capital. Risk management and protecting your portfolio becomes an after thought to making money and earning a high rate of return. How poor and ignorant this thinking has become.

The wording is subtle yet there is a powerful difference between return on capital and return of capital. The first is the return on the money you invest. For example, if you made $8 on $100 of invested money you would have an 8% return on capital. The later is the ability to at least get your $100 back at the end of the day and not lose any money.

Success Is Measured By How Much You Keep

I firmly believe we are entering another very tough and potentially devastating year for stocks. It feels oddly similar to the same market sentiment just before the crash in 2008 – just a new catalyst to trigger the fall (i.e. sovereign debt).

Back at the start of 2009 the best money manager and investors weren’t those who earned the highest return in 2008 but rather those who lost less than everyone else. Being a “smart” investor then meant having money left after the shit hits the fan and the same is going to be true of those investors in the coming years.

Looking back at my trading journal (and this blog’s archives) I know that what was so successful for me trading during 2008 was that I had small positions and a lot of put protection. Moreover, I stayed mostly in cash and waited for the best opportunities to come out before I put money at risk. Living through that time and surviving taught me to focus my attention on return of capital.

From $20/share to Bankrupt In Just 5 Days

Above my computer in my office is a picture of the October 1929 crash newspaper front page. It’s there to constantly remind me of what can happen seemingly overnight. The systematic risk factor that is prevalent in all markets.

Lehman Brothers Stock Chart

Lehman Brothers is also a classic example and still recent enough to remember the pain of a market crash. Keep in mind that it took just 5 days for Lehman to go from a $5 stock and still worth millions of dollars to bankruptcy. And even 9 months before the crash Lehman was a $60 stock. Always remember how quickly things can turn!

Add your thoughts below in the comments section about the top strategy you are going to use to protect your portfolio this year?

  • Jonathan

    Great post. Thanks for reminding us to always be conservative and preserve our capital.

    • Kirk

      #1 rule of investing right :)