April 2019 – Unproductive Gains and the Power of Losses

April 2019

Unproductive Gains and the Power of Losses

April 25, 2019

Please read the important disclaimers at the bottom of this post. Past performance is not indicative of future results. Not a recommendation to buy or sell securities. Nothing in this presentation is intended to be construed as investment advice.
You may be surprised to learn that there is no school for financial advisors. In fact, one of the dirty secrets of the industry is that terms like financial advisor, investment advisor, financial planner, consultant, etc. don’t mean much in terms of experience. Unlike the term “medical doctor,” where the patient can be reasonably certain the individual performing services has received the requisite amount of training, education, real-world experience, and testing required to obtain the title “medical doctor” – and has been subsequently licensed by the medical board. State and federal securities regulators mandate that everyone is licensed (or exempted, through one of five certifications/accreditations). These licensure tests make sure to cover the law, ethics, and a small amount of finance theory. Knowing and following the law should certainly be a primary focus, but in the case of these tests it is the primary focus. There is no deep dive into financial topics – just a light check to see you know enough to start out in the industry. But not breaking the law does not translate to not breaking the client’s bank account. It is amazing to think that there is no standardized education for the industry; many professionals take their lumps and learn through painful experience, except those lessons learned are almost without exception with clients’ money.
But this is not a piece about how the industry needs to rally and root out the bad eggs. It’s more to share with you a simple piece of information that may have slipped by you if you don’t have a thoughtful advisor that is more concerned with wealth preservation and growth than their monthly commission check. If there were a School For Investors, INV 101 would include some version of the chart below. Many advisors refer to this chart when educating clients on the need for diversification, avoiding risk, and limiting loss. Though many professionals have been taught to estimate risk by solely looking at an investment’s volatility (the magnitude of its returns over time, both up and down), even the most novice investor will tell you that his or her real worry is losing money. Long-term or permanent loss of capital is devastating for wealth creation, and it goes without saying that the more an investment loses, the harder it is to get back to even. Here’s a quick example:

Suppose a $100,000 portfolio loses 20% one year and gains 20% in the next. Though the “average return” is zero, the investor actually loses money over the two-year period. In the first year, the portfolio loses 20%, or $20,000, to finish the year at $80,000. The next year, the portfolio gains 20% of $80,000, or $16,000, to finish the year at $96,000. In order to fully recover the $20,000 loss in the second year, the portfolio would have needed to gain 25% on $80,000. If the investor first gained 20% followed by a 20% loss, the end results are the same - $96,000. This effect is more pronounced as losses worsen. A 50% loss, for example, requires a 100% gain (meaning the portfolio must double) to get back to even. Such a large loss generally leads to prolonged recovery periods. In the Great Financial Crisis, the S&P 500 Index lost nearly 51% from Nov 2007 – Feb 2009 and did not recover those losses until March 2012. This means the Index went 52 months without any new gains.

The last two quarters perfectly displayed the impact of volatility drag. The fourth quarter of 2018 was horrible for the stock market; the -13.52% quarterly return for the S&P 500 was the 5th worst quarter in the last 20 years and compares to quarterly returns experienced in the depths of the financial crisis, the technology bubble bust, and the European debt crisis of 2010-2011. In the first quarter of 2019, the S&P 500 came roaring back, mostly due to a seemingly imminent conclusion to the trade dispute with China (which still at the time of this writing has yet to be resolved) and a more cautious Fed, which opted to pause its rate hikes indefinitely rather than continue raising them as it had planned to do. For the quarter, the index gained 13.65%, which is the 5th best quarter in the last 20 years. So, does a -13.52% quarter followed by a 13.65% gain equal a positive return over the 6-month period? No, it equals a 1.7% loss. The market would have needed to gain over 15.6% to fully recover the losses from the prior quarter.
Last month, our friends at CMG (Capital Management Group) did a webinar with ETFTrends and VanEck where they discussed how to survive market volatility. In it, they presented an interesting study by Ned Davis Research which showed that over the last 90 years, markets reached new highs only 34% of the time. The remaining 66% of the time was spent in a falling market (23%) or in recovery from a fallen market (43%). This means that, at least for buy and hold investors, markets were generating new wealth approximately one third of the time, a segment referred to as “New Wealth Creation Opportunities” in the chart below. This is a critical point: if a market is not reaching a new high, it is merely recovering a previous loss and therefore is not generating new wealth.

There are ways to make portfolios more efficient, more resilient, and more primed for new gains. This necessarily revolves around reducing portfolio drawdowns. Minimizing losses keeps an investor’s wealth nearer to its highs, which allows new wealth to be generated more easily. For most investors looking to improve the ratio of wealth creation opportunities, we advocate implementing a mix of the following:

  1. Income: Boiled down to its core, investing is about finding neat ways to get paid for taking risk. For example, when you buy a growth stock, you get paid with long-term earnings growth (and hopefully the stock price growth to match) but take the risk that the company won’t make it. Investing in income-producing assets like bonds or dividend-paying stocks ensures that investors are paid tangibly to take risk, and the reinvestment of investment income obviously improves the ability of a portfolio to compound wealth over the long term. In fact, the study cited above is based solely on price performance of the S&P 500 (it does not include return attributed to dividends) and including the income element of stocks would certainly improve the wealth creation characteristics over time but would not fully eliminate the volatility drag of large drawdowns.
  2. Diversification: We have touched on diversification in various forms in previous notes, but the loss-dampening effects of including, for example, a mix of stocks and bonds in a portfolio helps insulate a portfolio from the wealth destruction of large losses. Also, frequent rebalancing of a diversified portfolio helps investors take gains from the best performing assets and add to asset classes that have fallen, which takes advantage of the cyclicality of markets over time.
  3. Allocations to Alternatives: the term “Alternatives” is a broad brush stroke that can mean any of a number of different strategy types, each with its own risk profile and ability to protect investor capital. We focus on developing and allocating to data-dependent strategies that can reduce risk when market environments are uncertain and in some cases, can capitalize on falling prices. Other investment options that target these same characteristics are certain segments of the hedge fund universe, though hedge funds in general suffered disappointing performance in 2018 and have not bounced back as well along with equity markets so far this year.
No single approach to building portfolios is a panacea, which is why we advocate a blend. Over time, our view is that this focus, implemented in a disciplined format, will help keep investors producing more wealth by avoiding the devastating impact of losses. When it comes to the current market outlook, our data tells us that the picture is mixed. On the positive side, markets are rallying, earnings season is off to a great start, the Fed seems content with its interest rate level for now and has opted to pause its hikes. However, global growth appears to be slowing, with the IMF cutting its 2019 forecast once again. The yield curve in the US remains inverted out to 7-years at the time of this writing and home & auto sales have also been very weak. The yield curve and home/auto sales data are both worrying; these signals are typically indicative of future recession. At the same time, valuations remain near historically extreme levels despite growing earnings. If a recession is accompanied by a bear market, as has been the case several times over the last few decades, losses would likely be significant. To be clear, the immediate and nearly full snapback experienced in the first quarter of 2019 is a very rare phenomenon for equity markets, and investors shouldn’t rely on risk management to continue to come in the form of a soothsaying Fed. Large losses are not typically recovered quickly; as mentioned above, it took buy and hold equity investors over 4 years to recover from the losses in the last crisis, using the S&P 500 as a proxy. In a more stunning example, the technology-heavy NASDAQ Composite didn’t recover it’s February 2000 high until 2014, meaning investors went nearly 15 years without any new wealth creation – and that’s not even adjusting for inflation. If you do adjust for inflation, the NASDAQ Composite didn’t recover its February 2000 high until late 2017. For some investors with an ultra-long-time horizon, maybe that is a risk you are willing to take. For most, though, it may be wise to include other approaches that focus on “New Wealth Creation Opportunities” by limiting the impact of market downturns.
Thank you to everyone for your feedback. Please feel free to reach out at any time with questions or comments.
Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments
Important Disclaimers
The information contained in this presentation is qualified in its entirety by the following disclosures which must be read in conjunction with the presentation. The presentation is intended for sophisticated investors for informational purposes only and is not intended to constitute investment advice or recommendations by any party. Unless otherwise indicated, information, data, strategies and opinions included in the presentation are provided as of 04/29/2019 and are subject to change without notice. In accordance with relevant SEC advertising regulations, a full list of trades and investment recommendations is available upon request. Past performance is not a guarantee or a reliable indicator of future results. The views and strategies described herein may not be suitable for all investors. You should consult your financial advisor regarding such matters. The material contains the current opinions of the author, and such opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based on proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. This material contains information that has been prepared from original sources and data believed to be reliable. However, no representations are made to the accuracy or completeness thereof. Investing involves a variety of risks and may be only appropriate for sophisticated persons who can afford a loss of all or a substantial portion of their investment. No part of this material may, without advance written consent, be copied or duplicated in any form by any means. There can be no assurance that any client’s investment objective will be achieved or that a client will not lose a portion or all of its investment account. The investment return and principal value of any investment will fluctuate over time. No chart, graph, or other figure provided should be used to determine which investment strategies to use or which securities to buy or sell. No figure above should be taken as a recommendation or endorsement of a specific security, sector, or strategy. References to market or composite indexes, benchmarks or other measures of relative market performance over a specified period of time are provided for information only and do not imply that any client account will achieve similar returns, volatility or other results. The composition of an index may not reflect the manner in which a client’s portfolio is constructed in relation to expected or achieved returns, portfolio guidelines, restrictions, sectors, correlations, concentrations, volatility or tracking error targets, all of which may change over time. An index’s performance does not reflect the deduction of transaction costs, management fees, or other costs which would reduce returns. You cannot invest directly in an index.