Wednesday, December 25, 2013

Prudent risk management as vital as ever

In no way does the following necessarily reflect the Goldrock view, nor constitute any advice whatsoever, investment or otherwise; the purpose of this posting is to remind ourselves how devastating losses are; and maintain a disproportionate impact on ones' portfolio; and the ensuing gains required to recover from losses. Significantly, as the magnitude of the loss increases, the required recovery gain increases EXPONENTIALLY.

As 2013 draws to a close, few would have predicted this time last year that the S&P would be finishing the year some 30% higher than it started the year. Those who were indeed fortunate enough to fully participate in the stock market rally will be rubbing their hands in glee. But what does 2014 bring about? The trend is your friend, right? Well yes ….. until it isn’t. There is high temptation to follow the momentum of 2013 and jump headfirst in the stock market.

Markets tend to be somewhat "mean reverting" over time. The good times don’t last for ever, and consummately neither do the bad times. In the good times, or what is commonly known as an equity bull market, simple buy and hold strategies would perform very nicely indeed. You would fully participate in market up-ticks. However, during a bear market, you would perform woefully, and would be at the peril of the market.

On the flip side, prudent active management allows one to use diversification, investment selection and skill to limit the downside, whilst giving up some of the upside. In bull markets, you will undoubtedly underperform, however, should be able to sleep better at night, knowing that in a downturn, when the market plunges, your portfolio ought to suffer far less.

That’s the theory. How does it play out in practice?

Lets assume the market drops by 30%. And then recovers 43%. An investor who starts out with 1,000 will decline to 700 and then recover back up to 1,000. An investor fully in the market, would have returned nothing. An investor though who constructs his portfolio that should limit the downside risk whilst participating in some upside would have made a positive gain over the same cycle. Lets assume his portfolio is constructed with a beta of about 0.5. He would expect to participate in about half the markets upside, and half the markets downside. Under the exact same scenario, where the market drops by 30% and recovers 43%, this investor's portfolio would expect to drop 15% and then recover 21.5%. His portfolio ought to decline to 850 and then recover to 1,033. So whilst the market portfolio experienced lots of volatility, twists, turns and excitement, but ultimately returned nothing, our astute investor would have made a small gain.  Due to compounding, his gain grows exponentially over various market cycles.

That’s a nice theory. Does it hold up in practice though?

At the beginning of 2000, the S&P 500 was at 1469. Fast forward to October 2002, and the index stood at 777, some 47% lower. Moving on 5 years and a performance of 101%, the S&P stood at 1565. On to March 2009, the market low was at 666, a loss of 57%. Currently, a bit less than 5 years after that low, we are at 1830, a gain of 174%. Over the 13 year period, a buy and hold investor would have been up 24%. Lets return to our astute investor, who has constructed his portfolio with a beta of 0.5. He would expect performance to the tune of -23.5%, +50.5%, -28.5% and +87%. Overall, his 1,000 would have declined to 765, risen to 1,151, declined to 823 and then risen to 1539. His cumulative performance would be 54%. So whilst there would have been periods, often long ones at that whereby the market (and the buy and hold investor) would have performed considerably better, in the bigger picture and over the longer term his portfolio would outperform considerably.

Remember, this is due to the disproportionate impact of losses in relation to the gains required to recover from a loss. As the losses increase, the required gain SIMPLY to reach break-even also increases, EXPONENTIALLY. As the table shows, if the market goes down 40%, then the buy and hold market investor requires 67% gain, just to recover his losses and break even. The other investor, only recovers a 25% gain to recover his loss. If the market goes down 50%, then the buy and hold market investor requires 100% gain, just to recover his losses and break even. The other investor, only requires a 33% gain to recover his loss.

Whilst the temptation to plunge into the market remains as strong as ever, prudent risk management is vital!

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