June 9, 2017
Why is risk aversion important if you’re looking for consistent portfolio growth? Because big losses are hard to recover from!
For example, if your portfolio suffers a 50% drop in value, you need a 100% increase to get back where you started. That’s why a tactically managed approach emphasizing downside risk management is important. While downside risk management (a.k.a. risk aversion) doesn’t protect against all losses or guarantee a profit, a smart portfolio can reduce risk when the market declines.
To explain let’s use Aesop’s fable about the race between the tortoise and the hare. In the original story, the tortoise wins the race because he is consistent. In a multi-asset portfolio context, two hypothetical portfolios are racing:
The first portfolio has a lower average annual arithmetic return. Because it runs slower, it’s our tortoise. However, the portfolio is well diversified, resulting in lower volatility. I’ll name our tortoise Cal Ripken because it consistently performs. There are very few losses and when they lose it is fairly small and easy to recover from. Steady wins the race. Making fewer errors and getting “on base” more creates a higher overall return.
The second portfolio has a higher average arithmetic return, so it runs faster. It’s concentrated in a single asset class using a buy and hold strategy which means it’s a higher volatility portfolio. This is our hare, and I’ll call him Mark McGuire. Although the hare occasionally “hits it out of the park”, there are more strikeouts than hits. Despite a few times where returns exceed the market, there are also times of excessive loss. This can be very destructive to a portfolio, especially if you are making withdrawals.
In this analogy, the lower volatility tortoise portfolio has fewer and/or smaller setbacks. It has more consistent average annual returns that can compound more smoothly. Because of this, it’s able to achieve an equivalent or higher geometric return than the hare portfolio. The tortoise may not be a homerun hitter, but it isn’t strikeout either. That’s especially important when talking about your life’s savings.
The setback penalty for the higher volatility portfolio is known as volatility drag. It’s also the reason a tactically managed (tortoise) portfolio has a good chance of matching or beating an equity (hare) portfolio. Over one or more full market cycles, the tortoise generally produces more plusses than minuses.
If you are one of many investors who simply can’t stomach market downturns, it’s a big deal. Often resulting in people selling and going to cash, they don’t know when to re-enter markets. In addition, if you’re approaching, or in retirement, you can’t afford big losses combined with little to no return.
In fact, the impact of volatility on your portfolio is more adverse once you begin making cash withdrawals. Imagine what happens if your portfolio suffers a 50% decrease, and the timing coincides with needing a new car, or medical expenses? In this scenario, you may have to withdraw cash from your retirement portfolio at the worst possible time. Even if your portfolio subsequently enjoyed strong returns, it may never get back to its starting level within your lifetime!
During market setbacks, half of winning is not losing (much). When the investable assets you have to choose from are declining, there’s nothing smart about holding hem, taking the loss, and waiting for assets to recover. You can’t endure excessive losses with funds needed to generate income for your retirement that may last 20-30 years.
The impact of withdrawals on your portfolio performance is known as cash-flow drag. Viewed from a cash-flow drag lens, the slower but more consistent “tortoise” portfolio may be a more compelling investment option than the faster (but more volatile) “hare” account.
If you are retired or plan on retiring soon, a big stumble could be crippling for your portfolio. That’s why you need to look at risk aversion (downside risk) in a different way. You should focus on wealth preservation strategies rather than “long-run/ home-run” average rates of return.
In a nutshell, that’s why managing downside risk is a key ingredient of a tactical portfolio management strategy. I believe other core ingredients include broad diversification, skilled money managers in every asset class and strategy, dynamic management, and risk aversion. Although no approach will protect against all losses or guarantee a profit, risk aversion may help reduce the magnitude of losses.
Putting our Cal Ripken tortoise in your portfolio might just increase your overall batting average.