Investors should keep in mind how large gains and losses may affect overall returns. This brief excerpt is a reminder why managing risk is important when investing.
Let’s review two hypothetical scenarios. There are two clients who are choosing to self-direct their investments, and each will need the money invested in six years. They each begin with $1,000,000.
Client A is an aggressive investor, and invested his entire portfolio in the Stock market. He experienced a 50% loss the first year. The subsequent 5 years his portfolio grew 15% annually.
Client B is a more conservative investor. He invested his portfolio in a more balanced portfolio of Stocks, Bonds and Alternatives. He lost 25% the first year. The subsequent 5 years his portfolio grew 7.5% annually.
Which client has more at the end of 6 years?
Without doing the calculation, my assumption is many people would assume they have the same amount. Since Client B lost and gained half of what Client A lost and gained, it’s natural to come to that conclusion. However, that’s not correct.
Client A’s portfolio was approximately the same value at what he initially invested, $1,005,678. The value of Client B’s portfolio was $1,076,722, $71,044 more than Client A.
While Client B had a much lower annual return, he ended with a higher amount because after the first year his investments started from a higher base of $750,000, compared to $500,000 for Client A. Therefore, he didn’t require double digit annual returns to outperform Client A.
The example above serves as a reminder that achieving the highest return and ignoring risk, maybe an inferior strategy to one that’s targeting strong returns, with an emphasis on risk management.
As a visual aid, please reference the attachment provided by Real Vision Publications and Michael Lebowitz at 720 Global which makes it easy to visualize the amount of return one has to capture to break even once losing 10%, 25%, 50% and 75%.
Nobody wants to experience a 25%, 50%, or any decline for that matter. However, it’s important to understand how occasional drawdowns can affect performance. While nobody knows when these drawdowns will happen, it’s critical for some investors to incorporate assets that have the potential to appreciate if stocks decline which will hopefully minimize drawdowns when they occur.
Timing the market involves selling at the peak and buying close to the bottom. History tells us this is a poor long-term strategy because it’s virtually impossible to execute. History also suggests excess cash or cash reserves is a poor long term investment as it will most likely underperform inflation. I refer to this strategy as one that’s “safely losing money”.
My opinion is investing in a diversified and balanced portfolio is a strategy to adhere to with the intention of capturing as much upside of the market while trying to minimize losses if markets were to decline.
Philip B. Snyder, CFA