Higher Risk Does Not Equal Higher Returns

Back in 2013, I outlined research supporting the less risk = higher returns thesis in Why Risk Matters. Due to the asymmetry of returns required to recover from portfolio losses, it is possible for an investor to take less risk and simultaneously achieve higher long-term returns. This is a key principle that guides our portfolio management decisions, and it is never more important than during market declines.

The notion that higher returns require taking higher risks has been propagated by Wall Street to the point that it has become a widely accepted truism. (Coincidentally, higher risk assets are often accompanied by higher fees for Wall Street.) In reality, higher risk-taking provides only the potential for higher returns, but also increases the potential for dramatically lower returns. And if you buy a risky asset at a high price, you can be nearly guaranteed to receive lower or negative returns!

When we evaluate methods to reduce the risk of a portfolio, we are typically measuring the resulting “downside capture” or “maximum drawdown”. If we can walk through a 40% market decline and only experience a 12% decline in our portfolio, we have obviously taken significantly less risk than the market. From there, the asymmetry of the returns to recover (67% vs. 14% required to recover from a 40% vs. 12% loss respectively) takes over to provide the higher long-term returns we are seeking.

Looking at historical data, is it not difficult to recognize the benefits of a portfolio designed to limit losses. Below is the historical return comparison of an allocation designed to minimize downside capture (Portfolio 1), versus a traditional 60/40 allocation (Portfolio 2), and a 100% U.S. stock allocation (Portfolio 3) from 1972 through 2015 (the longest period that we have data on all the asset classes):

Screen Shot 2016-01-28 at 9.30.43 AM

Screen Shot 2016-01-28 at 9.28.42 AM
Source: portfoliovisualizer.com

For the past 44 years (and numerous shorter time-frames, including the last decade), Portfolio 1 generated consistent returns exceeding the stock market (see the “CAGR” column, Compound Annual Growth Rate). At the same time, the maximum loss experienced was under 12% versus over 40% for the all-stock investor, and 22% for the balanced investor.

Historical data is easy. So how do you limit the declines in real-time looking forward? There are a number of methods available. Our preference is to carefully design the asset diversification based on expected returns for each asset class and modify it as the expected returns change over time. Then, avoid a few key portfolio management mistakes that can lead to significant losses — including overpaying for assets, inappropriate use of leverage, investing in opaque or illiquid assets, and following investment fads.

It is easy to ignore and even forget these principles during bull markets such as the one we have experienced since the 2008/2009 financial crisis. If the start of 2016 is any indication, now would be a very good time to ensure your portfolio incorporates them.

I need to point out that the compound annual growth rate of 10.34% in the historical data is not a number you should use for expected future returns. The world is very different today than it was in 1972, and we are adjusting expected returns and our portfolio management techniques accordingly.