April 2019Unproductive Gains and the Power of Losses
April 25, 2019
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.
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:
- 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.
- 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.
- 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.