Want your investment portfolio to beat the market? Lower your downside risk.
For the past fifteen years, I have worked diligently with a select team of managers and index developers to design diversified portfolios that will meet client goals using the simple concept of reduced risk. In a research article in this month’s Journal of Financial Planning, Jerry Miccolis and Marina Goodman do a great job of explaining how reducing risk impacts the long term success of our portfolios.
To begin, you need to understand something we call the asymmetry of positive and negative returns. Simply put, if you invest $1 million in the market and experience a loss of 50%, your investment is now worth $500,000. In order to get back to your $1 million starting point, you now need to generate a return of 100%. If you lose 40%, you’ll need a 67% return to get back to where you started. However, if the loss is contained to 20%, only a 25% return is needed to restore your $1 million.
So, recovering from small losses is easy. Recovering from large losses is not, and can be particularly devastating if you are near retirement or taking annual distribution from the portfolio.
With the right amount of diversification and avoiding the latest investment fads, designing a portfolio that experiences 65% of the stock market’s positive returns and only 50% of the stock market’s negative returns is not difficult to achieve. And in many situations these up/down capture ratios can be even better.
Let’s take a look at how this impacts wealth creation. The following chart shows the total return of the S&P 500 over the past 20 years, compared with a reduced risk portfolio (S&P 500 returns adjusted for 50% downside and 65% upside capture).
Journal of Financial Planning, September 2013
Over the past 20 years, our approach of reducing risk generated more than twice the wealth of the higher risk index as illustrated above.
But there is one very significant caveat — you’ve got to stick with it! There are periods in the market where the S&P 500, or some other indexed asset class, generates a year or more of uninterrupted positive returns, while your reduced risk portfolio seemingly falls behind as it is only capturing part of the upside. Be patient. There will always be more market declines, corrections and crashes coming, each one creating new opportunity for your wealth to increase and your goals to be met.