May 23, 2017
I’m a risk manager. I always have been, I always will be. In my opinion, this is where out-performance and long-term investing success is born. The biggest way to make money is to not lose money. This can be especially true during bear markets. Or, as I’m fond of saying: “half of winning is not losing”. Is everything clear as mud now?
To help bring some clarity, I previously discussed establishing goals, selecting time frames, and identifying the correct benchmarks. I shared my view on the three ways to generate alpha (timing, selection, and leverage). Now it’s time to answer the question of trying to outperform benchmarks and not lose your hard-earned money.
Every active manager in the game attempts to provide outperformance with their methodology. As such, there are many ways to try and outperform. That being said, I agree that “markets work”; or put another way, markets go up until they don’t. I also get that investors need to ride out the vast majority of small or normal ranges of volatility. However, I firmly believe investors prefer not to see their portfolios lose 20%, 30%, or 50%.
Go ahead, do your own survey. Ask 10 investors if they would prefer to stay fully invested in stocks during the next bear market or shift to safe investments until the storm passes. In my experience, the answer is usually to move to safe investments. Therefore, I believe that there are times when the best offense a portfolio can have is to employ a good defense.
To be clear, I’m talking about the big-picture market cycles here. I’m not talking about trading in and out of the market every week. My goal is to get it right the majority of the time, especially in terms of the really big, really important bull and bear cycles.
If a market loses 30%, it needs to rise 42.9% from the bottom to recover from the fall. A decline of 40% requires a rebound of 67%. And if the decline hits 50%, a 100% gain is needed to break even. Every time I share this with someone they doubt it.
So, if you had $100,000 at the beginning of 2008 in the stock market using the SPDR S&P 500 index Exchange Traded Fund (SPY). The shares opened 1/3/2008 at $144.07 and by the close of December year end the share price was $90.24/ share. So, the math is a dollar loss of $53.83 per share or a percentage loss of 37.36% excluding dividend income.
So now the fun begins (if you are a geek, like me). If I had 1,000 of these shares at the beginning then I would have had $144,070 and ended with $90,240. Now what percentage am I required to make to get back to even? Is it 37.76% which would mean I have an average annual return of 0% over the past 2 years using a basic average approach? So, to get back to even I would need to earn back my $53.83/ share. So, divide that 53.83 by your current share price of $90.24 and voila’, you get a whopping 59.65% required return to recover back to even.
This is why Warren Buffett’s first rule of investing is, “Never lose big money.” And then rule number two is: “Never, ever forget rule number one.”
Here’s the key. According to Ned Davis Research, the average gain of the 36 bull markets that have occurred since 1900 has been 85.5%. And during the 18 cyclical bull markets that have occurred within secular bull trends (which is what NDR believes we are seeing now), the average gain improves to 106.7%.
To expand this line of reasoning, the average bear market since the year 1900 has experienced a loss of -30.6% and the average cyclical bear that occurs during a secular bull (which is what NDR expects the next bear to look like) loses -21.8%.
This is probably why we’re told to stay in our seats during market declines. The bull markets gain 80% to 107% while bear markets decline 20% to 30%. Up 100%, down 30%, rinse and repeat. The math works for long-term investors, right! Well, what if you need some of this money and are not able to wait until a market recovery? It’s your money and it is also your time line.
The problem is if investors stay in their seats and ride the bear down, winding up with a decline of 30% in the process, they are forced to use up more than half of the gain the average bull market enjoys (and 40% of the average gain that occur during cyclical bulls taking place in secular bull trends).
We need to manage that loss through strong math based formulas and lose minimally during the bears. Doing so means we can wind up with more money in the long run. Again, it’s about the math.
Regardless of what they say, no one else on the planet thinks losing money makes sense. This is true anytime, and especially during downturns. I strive to make as much money as I can during bull market trends. But I believe the real key to long-term over-performance is to manage the risk of severe market downturns. In short, I strive to lose far less during bear markets and park my clients’ money in safer investments until the downside stops going down.
For example, my trusty solar calculator says if we could limit the losses during bear markets to 5% or 10% (rather than 30%), we need a less aggressive recovery of 5.27% to 11.12% (instead of 42.9%) to get back to where we were before bear began. Better choices makes sense.
So, my goal is to create portfolios designed to (a) “track” the benchmark returns during most calendar years and (b) to “manage risk” when the bears come to call. As I’m fond of saying: “half of winning is not losing”.