HOW MUCH YOU MAKE DEPENDS A LOT ON HOW MUCH YOU DON’T LOSE

Much has been written about the mathematics of how large losses and outsized volatility impact investment returns. Not surprisingly, there are a number of fairly complex formulas that calculate a number of fairly complex measures — high-minded things like drawdown size, duration, and duration of recovery. In the end, though, all these analytics are doing is calculating how much damage “time under water” does to investment returns. Maybe the better way to a more satisfactory investment experience is to simply stay above the water as much as possible.

WIN BY NOT LOSING

In goes without saying, but we’ll say it anyhow: Avoiding large losses and minimizing volatility is critical to any fund’s long-term performance. The first hard task for any investor is to minimize drawdowns.

A drawdown is the loss incurred in a fund or portfolio from a high point in the fund’s value until the fund recovers that value. Problem is, an advisor’s ability to help his or her client climb back is more difficult than the fund manager’s ability to sink below the surface.

It’s all about the arithmetic.

While the attached chart is well-known to the investment community, its message tends to be forgotten after extended periods of forward- or sideways-moving markets. Why? Because, this is frightening math, especially when considering the number of large drawdowns equity markets have suffered over the last 40 years.

While the Financial Crisis of 2008/2009 may be closer to front of mind, it’s worth recalling a particularly nasty stretch earlier in decade when the NASDAQ Composite lost 78% from its high on March 10, 2000 to its low on October 10,2002. That time under water meant investors in the index needed to earn nearly 400% — or five times their remaining capital – just to get back to even.

As it turned out, it took the NASDAQ more than twelve and a half years to climb back to its March 2000 high.

Most investors don’t have that kind of time to wait for a recovery. Many didn’t. The millions of people heading for retirement when the market began sinking in 2000, again in 2008, most likely never recovered. It’s called the sequence or returns risk, and it diminished forever the financial quality of retirement life they had planned.

PLUG THE DRAIN

A second, and closely related mechanism to winning by not losing, is controlling volatility. Without market volatility, drawdowns would not occur and the sequence of returns risk to retirees would become irrelevant.

Volatility drag, also known as “variance drain,” operates under the notion that between two portfolios with the same beginning and same average return, the one with the less variance will have a higher compound return. Mathematically, it can be shown how volatility increases the difference between the average return and the actual return of an account. Again, it’s all about the arithmetic.

The existence of volatility and variance drain essentially renders the popular term “average annual return” almost meaningless. Market returns vary significantly each year, and to project a theoretical return on that basis is misleading.

ENJOY A NEARLY-FREE LUNCH

So, given the difficulties an investor faces trying to keep his or her head above water, just how does he or she go about keeping losses manageable and volatility to a minimal level?

The broad answer is diversification. It’s the closest thing to a free lunch in finance. But we’re not talking about simple buy, hold, and pray-the-market-never-goes-down kind of diversification. In practice, finding investments that have low or negative correlation to each other — on a continual basis — is harder than that. A lot harder than that.

What we’re talking about is combining investments with positive expected return and relatively high volatility in a way that minimizes portfolio volatility while not degrading returns. And doing so in a systematic, repeatable way that adjusts to current market conditions.

Investors can do better than simply “holding on” through dramatic market downswings. It’s the first step toward winning by not losing.


The views in this commentary are those of Fund Architects. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this commentary, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from Fund Architects or any other investment professional.  The information contained within this commentary should not be the sole determining factor for making investment decisions. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with Fund Architects. Information pertaining to Fund Architects advisory operations, services, and fees is set forth in Fund Architect current disclosure statement, a copy of which is available upon request. Fund Architects, LLC is an SEC Registered Investment Advisory Firm.

 

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