- When considering an investment, downside risk should be given just as much, if not greater, weight than expected upside returns.
- This article shows the high cost of losses on a portfolio and proposes various strategies to help investors preserve their capital.
Seth Klarman, a successful investor and hedge fund manager states “most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.”
Investors are trying to make money - that is why they are investing after all. It is easy to get excited about, and focus primarily on, the potential upside. Sometimes this results in pushing any consideration of an investment's downside risk to the backseat.
In this article, we will see how downside risk can have a significant impact to a portfolio's long-term performance as well as various strategies to protect against portfolio losses.
The high cost of losses
Take a look at the following table which shows the portfolio return required to overcome any drawdown.
The bolded line shows how a 50% drawdown requires a 100% return for a full recovery is shown in bold. The return required to reach break even is significantly higher than the loss. More insightful is the exponential relationship between the losses and the return to breakeven. As the loss grows, the return required to reach breakeven grows at a much faster rate. The 50% drawdown requires a 100% return, while a 75% drawdown requires a 300% return. Similarly, the smaller the loss, the less return required to return to break even. The graph below helps visualize the exponential effect of the return required as losses grow.
Besides the exponential recovery costs, losses also have psychological costs on investors. Demonstrated by Amos Tversky and Daniel Kahneman, people tend to prefer avoiding losses over acquiring the equivalent in gains. This is known as loss aversion. Tversky and Kahneman indicate people have a loss aversion ratio of between 1.5 and 2.5. Considering a loss aversion ratio of 2, the satisfaction lost with a loss of $100 is equivalent to the satisfaction gained with a gain of $200. In effect, losses are harder to stomach than gains of the same magnitude.
Upside of limiting losses
Any portfolio could benefit significantly from containing losses. The following graph shows the impact of 3 distinct scenarios since 1998.
The red line shows a portfolio that missed out on the 10 worst days; the green shows a portfolio invested in the index, simulating a buy and hold investor; and the blue line shows a portfolio that missed out on the 10 best days.
As evident from the graph, the best performing strategy is the one that missed out on the 10 worst days, yielding almost 4x more than the blue-line portfolio. The other 2 portfolios had to spend much more time recovering the losses, before being able to grow the portfolio to a new high. We saw above how greater losses have higher return hurdles to breakeven; this example shows a real world simulation of it in the market.
The next graphs show us a similar hypothetical example, but with some concrete numbers.
From these tables we can clearly see the magnitude of the impact in both scenarios. In missing out on the 10 best days, the portfolio would have missed out on gains of 60.45%. However, in missing out on the 10 worst days, the portfolio would have gained extra returns of 138.6%! From this study we see that, losses are generally greater in magnitude than gains. Losses occur quickly and strongly. These numbers show that investors are better off protecting against the downside risk instead of chasing gains.
While it is impossible to predict when the worst days, there are many things we can do to be ready for when those days do come, and hopefully limit some of the loss.
Strategies to limit losses and preserve capital
“It’s a little-known but startling fact: Since 1901, the Dow Jones Industrial Average has spent 76.4% of the time declining in value or recovering from loss and just 23.6% of the time creating wealth" -CMG
By working to mitigate losses, investors can preserve capital and also take advantage of the ensuing recovery.
Various portfolio management techniques help investors position their portfolio to be better prepared for potential drawdowns. Asset diversification reduces exposure to drawdowns from any particular sector. Hedging positions, whether by shorting similar investments or purchasing put options, can provide downside protection, similar to an insurance policy. A more simple hedge may just involve holding a larger cash position.
In terms of valuation, investors can reduce drawdown risk by being extra selective in the investment opportunities they take on. Fairly or under-valued companies will provide more downside protection than over-valued companies. Similarly, by acknowledging the market environment, investors can modify their portfolio accordingly. If markets are excessively valued, it may be a good idea to either stop accumulating equities or perhaps take some chips off the table.
By preparing for downside risk, investors will also be better prepared to take part in the ensuing recovery. After a drawdown, if valuations and the investments are sound, investors can decide to increase their position and dollar cost average their holdings, lowering their effective buy-in price. Funds could come from the larger cash position that was held, closing a hedged position, contributing new capital, or reinvesting dividends.
Preparing for drawdowns is not easy and requires great discipline. By purchasing insurance, holding cash, or hedging in a raging bull market, investors may feel like they are wasting good money. The longer the market goes, the more difficult it becomes. The contrarian stance is difficult to defend in the midst of everyone else making easy money. It takes a lot of discipline to keep focus on protecting the downside risk.
I compel investors to focus not only on potential upside from an investment opportunity, but to also carefully analyze the downside risk. As we saw, losses come at great costs. This article presents several strategies as ideas for investors to work with to form their own plan for downside protection. These strategies do not eliminate all losses, but if used correctly they can help contain losses. Not all strategies/techniques are appropriate for everyone, as it is highly dependent on each person's particular situation.