Limit Stock Market Losses to Improve Long-term Returns

men putting out fireInvesting in stocks can be brutal. According to research, the S&P 500 lost at least 10% from a previous high every two-and-a-half years on average, and at least 20% every six. A 30% loss happened every 13. It has fallen 50% from a peak three times since 1954. None of these declines were, or could have been, anticipated with any kind of precision, and they certainly do not come at regular intervals. And, remarkably, losses of this magnitude contradict the models we use to describe market behavior.

For example, the largest S&P 500 one-day loss was 20.5% in October 19 1987. According to a widely used model of stock market returns (which assumes that they form a bell curve around an average) the likelihood of the 1987 loss is similar to picking the right card in a deck containing as many cards as there are atoms in the known universe. In other words, the chance that such drop could happen is essentially zero.

Clearly the problem is not that impossible events happen but that our models are inadequate. A lot of analysts have tried to come up with better ones, but so far this quest has proven fruitless. We still can’t predict markets with any meaningful accuracy. This is why markets are not so much like the weather, as they are often compared, but rather like earthquakes, which scientists now admit are unpredictable.

But here is the good news: we cannot predict earthquakes, but we know how to build earthquake-resistant structures. Likewise, we cannot predict markets but we have techniques that can help us limit losses when markets tank.

There are some very basic reasons why limiting losses is more important than producing strong returns.

A well-known example goes like this: If you lose 50% of $100 you need a 100% return on the remaining $50 to break even. This means that a large percentage loss requires a very large percentage gain for full recovery.

But a far more important example is this: If you only lose 20% of $100, you will need just 25% to bring the remaining $80 back to $100. So a small loss requires much less effort to come out from it.

This is even more important for retirees who use savings to pay for living expenses.
For example, taking $10 after a portfolio falls from $100 to $50 leaves the saver with only $40. A subsequent 100% return only takes the portfolio back to $80. That means that the $10 withdrawal turned into $20 because of its bad timing.

But when $100 only falls to $80 and $10 are taken, a subsequent 25% recovery on the remaining $70 brings the value up to $87.50. This means that the $10 withdrawal turned into $12.50—a much smaller penalty for taking money out at the worst possible time.

The moral is clear: limiting losses is an essential element in portfolio management.
Limiting losses requires some basic processes in place. The best known is diversification, or investing in a mix of assets that tend to move in different directions. But a mix that looks diversified today may not be diversified tomorrow, especially when markets take a turn for the worse. This is because in down markets investors sell everything and correlations go up sharply. Therefore, a mix that does not take into account how the market cycle changes is prone to go through periods where diversification goes away just when investors need it most.

Adapting portfolios to market conditions requires dedication, patience, and a well-designed set of rules. This is, or should be, the professional portfolio manager’s job. Some investors insist that the portfolio manager’s job is simply to beat the market by picking a high proportion of winning assets. Accordingly, they are willing to pay a premium for those managers who seem to have the hot hands. This is a bad approach, commonly known as “chasing past returns.”

Many studies show that virtually no active fund can consistently beat its benchmark, and not because of fees. According to Standard & Poor, which publishes a regular analysis of fund performance, most funds underperform their benchmarks both before and after fees.

The simple explanation is that poorly diversified funds can only outperform their benchmarks through superior forecasting. But, just like for earthquakes, forecasting the market accurately is impossible. As one academic put it:

Going back to basics, the idea “to invest successfully in the stock market, you need to know whether the market is going to go up or go down” is just wrong. (Professor David Aldous, UC Berkeley – The Kelly criterion for favorable games)

While limiting downside exposure is crucial in portfolio management, having this protection in place at all times can be frustrating. If the market keeps on rallying, the “insurance” against declines appears to be an unnecessary drag on returns, just as going through the expense of building a house that is earthquake-resistant may seem like a waste as long as there are no earthquakes.

We all have complained about paying for insurance that we don’t seem to need. This is understandable as long as disaster does not strike. But the temptation to cancel insurance can be dangerous. If you are not yet convinced this is so, please reread the first paragraph to see why having a systematic process to protect investments from losses is a good idea.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours.

We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

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You May Not Be As Diversified As You Think

onionsDiversification is the key element when managing a portfolio. If you want to smooth the ups and downs of individual assets, combine them in a basket. The less correlated those assets are, the steadier the basket’s performance.

Implementing this simple concept effectively, however, is not easy. One major reason is that asset correlations change over time, both in magnitude and direction. For example, when interest rates fall, bond prices go up but stocks can go up or down, depending on whether investors think that lower rates as a stimulus for the economy, or that they are a sign that the economy is slowing down. Because the relationship between stocks and bonds changes over time, the “optimal” proportion of both in a portfolio changes as well.

It is very difficult to forecast changes in correlations. That’s why a common approach is to assume that they will remain constant – which is where the advice that a portfolio must contain a 60% stocks/40% bonds comes from. The assumption is that such pre-set allocation will be good enough to smooth volatility and produce positive results, even if at times it is not the “best” mix for achieving the sometimes opposite goals of maximizing returns and minimizing volatility.

Is it possible to obtain better results by actively managing a mix of assets instead of fixing it at some arbitrary level?

This question is sometimes dismissed out of hand because it sounds like asking whether it is a good idea to “time the market”, an activity that is generally thought to reduce portfolio returns. Indeed, many studies show that portfolio results tend to decline when trading activity increases. The reason behind this is not clear. Some studies blame transaction costs associated with more frequent buying and selling, while others blame behavioral biases – chasing winners; holding on to losers far too long; fear and greed, etc. that are absent when a portfolio is left alone. Regardless, it is not difficult to show how simple active strategies can outperform a passive approach.

For example, it is possible to improve returns over a simple 70% stock/30% bond strategy with the following rebalancing rule: if stocks outperform bonds in any six-month period, change the mix to 90% stocks/10% bonds for the following six months. Otherwise, change it to 50%/50%. In other words, give an extra 20% to the asset class that did better in the prior six months. This “momentum” rule clearly outperforms the “passive” allocation for any base mix of stocks and bonds –70%/30%, 20%/80%, or any other.

image 1Notably, the rule only improves results starting in the early 1990s, making little difference over the “base” allocation before then. This is because there was a substantial change in the correlation between interest rates and stock returns that started around that time. This phenomenon became clear in hindsight, and many of the papers that describe it were published many years after the fact. An investor dedicated to building portfolios on the basis of responding dynamically to shorter-term correlation changes could have achieved higher returns much sooner.

It seems plausible that looking at diversification in more dynamic terms can yield better results, and in fact dynamic techniques have spread widely in the last few years. This approach has been at the center of our practice since we started managing clients’ portfolios, and we focus on developing, improving, and implementing these techniques for individual investors.

While simple strategies like the one described can be effective over the very long term, their benefits over much shorter periods may be less apparent. This is important, because the usual life of an individual’s investment portfolio is often measured in years, not decades. One consequence of this is that for retirement portfolios controlling volatility becomes more important than maximizing returns. This is because pursuing higher returns exposes a portfolio to more risk, which can get in the way of protecting a savings portfolio so it can fund future living expenses. While a static allocation designed to reduce risk must reduce its expected returns, a dynamic allocation tries to find a way to capture more of the upside while keeping risk low..

The main goal of managing diversification dynamically is to provide a better trade-off between higher returns (more risk) and lower volatility (less risk) than a static portfolio mix. This is best achieved over the long term, since fixed allocations can, and do, outperform dynamic management over shorter periods. The process used to improve this trade-off is often a differentiating factor among portfolio managers who pursue the same goal.

What now?

We believe that our portfolio management process, focused on measuring risk, can be very effective at managing the trade-off between risk and returns. We implement this process for our clients, tailored for their specific circumstances, and we can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

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