With football season in full swing and the market at an all-time high I thought it would be a good idea to discuss risk adjusted returns. I can tell you are excited.
I’ve been doing this for almost 15 years now and if we are headed for another recession, which I think we are, it will be my third one. What I’ve noticed during these years, is how the conversation changes. When I first started here at CWM in January 2002, it was a very bad time for the market (tech bubble bursting) and advice from the financial media was to be proactive and have a disciplined exit strategy. A few years later things shifted and it was as if everybody was suffering from amnesia, because all of the sudden the conversation was around being passive (i.e. indexing) and keeping your costs low. Then, KABOOM! The Great Recession hits and guess what the conversation changed to... you guessed it, “you need to be proactive and have a disciplined exit strategy”.
For the past couple of years I’ve noticed the conversation is back to “being passive and keeping your costs low”; a strategy often referred to as Buy & Hold. This strategy works great in up markets because you get all of the up, but you also get all of the down in a down market. As a result, you end up giving back most, if not all of your gains during large market corrections. For example, let’s say that over the past five years you made 50%. At this point, you are a believer because you just made 50% and it cost you very little to do so. However, in year six, the market drops 30%. In the end, you only made 5%. How is that possible? Let’s apply dollars to it. Suppose you started with $100,000. If, after five years, your $100,000 grew to $150,000 but in year six the market drops and you lose 30% of your $150,000 which is $45,000. After all of that, you only have $105,000. As I like to say, 50 – 30 = 5 in a compound world.
Many of our clients are retired or nearing retirement and as a result, they are at the point in their lives where getting the big return is not nearly as important as NOT taking the big hit. For example, we picked up a lot of clients during the Great Recession that experienced around a 40%-60% loss in the drop of 2008. Many of those clients had to alter their lifestyle to a new reality as a result of those losses. With their portfolio dropping 40%+, they could no longer take out the same amount as before or they’d risk running out of money before they run out of time. If a retiree has a $1M portfolio they can take out 4% or $40,000 per year but if their portfolio dropped to $600,000 (40% loss) then they would have to reduce their draw to $24,000 per year. That is likely going to have a large impact on their lifestyle. This is why we focus so much on protecting the downside.
Our Performance Targeting System (PTS) aims to minimize the amount of risk you are taking to hit the target rate of return. Another way of putting this is that we are always shooting for “risk adjusted returns”. The problem with this approach is that it typically underperforms in an upmarket because of the measures taken to reduce risk. However, on the flip side, it typically does better in a down market as a result of those measures. Running with the example I gave above (again, see chart), suppose you made 40% over the same five years in a defensive portfolio while your friend made 50% in a passive portfolio, and you paid us a management fee to do so. At this point you are seriously questioning whether our fee is worth it. Then, in year six you lose 15% while your friend loses 30%. After six years you made a total of 19% and your friend made 5% even though you underperformed five of the six years. Our goal is to try and outperform by reducing your volatility. This is why I titled the article Defense Wins Championships.
If you have questions or comments about the material presented above, please don't hesitate to e-mail me at BrianL@CWMnw.com. Don't forget to share this information with others that may find it helpful.
This article has been prepared and distributed for informational purposes only and is not a solicitation or an offer to buy any security or investment or to participate in any trading strategy. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a financial professional. Past performance is no guarantee of future results.