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3 Lessons From a Super-Investor's Slip

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"Watch the downside, the upside will take care of itself. That's been a very important guiding philosophy for me. Our goal is to preserve principal, not to lose money. Our investors will forgive us if our returns don't beat the S&P in a given year, but we are not forgiven if we have significant drawdowns."
-- John Paulson, 2007

It's been a horrendous August for John Paulson, the hedge fund manager who rose to prominence after earning billions of dollars for himself and his investors betting against subprime securities. As of Aug. 19, one of his flagship funds was down 22% for the month, and 39% year to date.

Here are three lessons ordinary investors can learn from Paulson's experience:

Make sure your capital is available for as long as you need.
If you consider that shares are simply value-conscious, publicly traded ownership interests in an underlying business, then with very few exceptions, the only appropriate timeframe for investing in shares is a long one. By "long," I don't mean a year-and-a-half. I mean five years, at the very minimum.

Most hedge funds offer their investors the opportunity to redeem their investment on a quarterly basis. That doesn't fit well with any value-oriented stockpicking strategy, in which you might have to wait several years for the investment to play out. You simply can't do that when you need to close the position in order to raise money for redemptions.

Paulson has an advantage in this area. In an Aug. 5 letter to his investors, he reassured them "that over 36 percent of the assets in the strategies are held by partners in the firm who have no intention of redeeming." That is a significant chunk of assets under management  all but guaranteed to stay put. However, speculation has grown regarding the size of redemptions the firm will face in the fourth quarter. (Total redemptions in the third quarter came in below the fund's average over the last two years.)

Before you put any money in stocks, ask yourself: "Is it likely that I will need to redeem this money on short notice or within the next five years?" If you answer "yes," you'd be ill-advised to risk your money in the stock market.

Cut permanent losses short, even if they are significant (and don't confuse an investment with a speculation.)
When shares of Chinese timber company Sino-Forest dramatically declined after a short-seller questioned the honesty of the company's financial reporting, Paulson didn't hang around to find out whether those charges were true. He had the courage to book a loss of nearly $500 million, rather than sit around hoping that the losses would reverse. He understood that the position had gone from being an investment to a speculation, took his licks, and moved on. That decision looks wise in light of the most recent developments concerning Sino-Forest and its stock.

Avoid being too concentrated in a single industry or a single stock.
By definition, a stock picker doesn't want to be fully diversified; in that case, you'd simply end up mirroring the market. However, you also don't want to isolate all your holdings in just one or two sectors.

Paulson consciously made a big sector-level call on financial stocks, betting that banks including JPMorgan Chase (NYSE: JPM  ) , Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) would perform well as the economy recovered. That may well turn out to be the case -- in fact, I think it's likely -- over the long term. In the meantime, Paulson's large exposure to financial stocks has contributed to sizable mark-to-market losses in some of his funds, as bank shares have plummeted.

It takes an unusual temperament to experience large losses with equanimity. Paulson himself may have that temperament, but most of his investors don't. He now recognizes that his fund(s) had too much exposure to banking shares, and he's begun scaling back some of his positions.

While he's now reducing his exposure to banks, I think he may be committing the same error with his bet on gold. All of Paulson's funds are also available denominated in gold. Paulson maintains his own investments in his funds on that basis. As a result, Paulson & Co. is the largest shareholder in the SPDR Gold Trust ETF (NYSE: GLD  ) , and the ETF is the firm's largest holding by a wide margin. At the end of June, the firm held 31.5 million shares, valued at $4.6 billion -- 16% of the total assets listed in the report of holdings. Add to that some very large positions in gold miners, including Barrick Gold (NYSE: ABX  ) .

It would be very difficult to reduce that startlingly sizable stake amid a major correction. Long gold looks like a crowded trade with many inexperienced participants, although there are fewer now than there were at close to $1,900 an ounce. Crowded trades and huge positions are a very dangerous combination that can produce massive losses.

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Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of JPMorgan Chase, Citigroup, and Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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