Very good years, followed by very bad years

Why volatility is risk. When returns go down 50%, you have to make 100% in order to break even.

Bloomberg Businessweek on Paulson’s great subprime  year, which has been followed by rough years.

One institutional investor, whose firm withdrew its money from Paulson’s funds in 2011, says that most hedge funds follow a familiar developmental pattern. During the first stage, funds often improve quickly, but they’re also small and therefore difficult for large institutions to invest in. The second stage is when the fund’s managers are working hard and have shown some success; that’s when the upward curve is steepest, and the most astute investors get in.

Stage three, which the institutional investor called “cresting,” usually comes after the fund has become quite large and performance starts to drop off. “By stage four, they are starting to buy baseball teams and those kinds of things,” says the investor, who asked not to be identified because it might affect his company’s relationships with other fund managers. “It’s not always the case, but we found that with those stages, performance is usually not as good as it was earlier.” The investor adds, “I think for us that was a danger. We consider them a three or four—we knew they definitely weren’t a one or two.”

Full story here.