In learning how to invest money we can look to sports for useful metaphors to guide investors.
There are sayings in sports such as “Offense wins games and defense wins championships” or “A great offense is a great defense”. In truth, every great team must have both a solid offense and defense but the importance of the defensive team cannot be understated.
In football, a good defense that can keep the opposing team from scoring makes it easier for the offensive team to win. A strong defense often leads to controlling the ball more often and having better field position. And then there is the psychological advantage that a dominant defense can have when it shuts down the opposing team’s offense.
In baseball, there is the example of the no-hitter – a complete game in which a pitcher yields no hits to the opposing team.
In hockey, a team can win by only scoring one or two goals, but it is very rare that a team wins when the other team puts up four or five. One has to look no further than the recent Stanley Cup series between the Blues and the Bruins for this example.
When it comes to investing, however, most investors are of the mindset to be constantly playing offense. Yet, investment markets spend most of their time declining and recovering from those declines. A powerful fraction of time is spent creating new capital or making new money. A study by Morningstar Direct for time period 1/1/1994 to 12/31/2018 revealed that U.S. stocks spent only 19% of that time creating new capital. The other 81% of the time was spent in decline and recovery.
For international stocks, the time spent creating new capital was even less; only 11%
Given these facts, then why do so few investors have a defensive strategy? Why do most investors only consider playing “offense”?
Without an effective risk management strategy, a portfolio may spend excess time in decline and recovery, rather than creating new wealth.
The math of losses
It’s also important to understand that any loss, requires a greater gain to recoup the loss. As the following table illustrates, a 20% loss requires a 25% gain to get back to breakeven. For a 50% loss, similar to what investors witnessed in 2008-2009, it requires a 100% return to breakeven!
The other side of this coin is time. While an investor may eventually recover financially from a market loss, what is never recovered and is forever lost, is the time that it takes for the portfolio to return to breakeven.
And this assumes that (a) an investor has the mental resolve to stick it out and doesn’t panic and sell somewhere along the way, and (b) that the investor is not having to liquidate portfolio holdings in order to maintain living expenses.
In the former example, I know of several investors who panicked and sold, one after the dot.com crash in 2002 and others after the credit bubble crash in 2008, and they NEVER got back in the market! One can not overestimate the psychological scar that large market losses can inflict.
In the latter example, market losses can compound as a result of investors being forced to sell holdings at lower prices often resulting in a permanent loss of capital.
I have previously discussed the importance that sequence of return risk plays in retirement portfolios.
For retirees especially, having a defensive strategy should be considered a top priority since both resources and time are diminishing and market losses may increase the chance of running out of money.
For younger investors, market losses will have an impact on the sum of money that they can accumulate. It sounds silly to say “you can’t compound your losses”, yet few investors understand the importance of keeping losses small.
A quick lesson in math
In school, we are taught that an arithmetic average is calculated by taking the sum of the units being measured and then dividing by the number of units.
For example, if we wanted to know the “average” height of the students in a classroom, we would simply add up the height of all of the students and then divide by the number of students.
The arithmetic average is effective in situations where each of the items being measured is independent of one another. The height of one student does not have any impact on the heights of the other students.
By contrast, in the world of investment returns, the results of one year are related to the results of the next, because both are being compounded on a dollar amount that grows in year 1 (by the returns of that year) before being reinvested (or continuing to be held for investment) in year 2. As a result, a simple arithmetic return fails to capture the compounding effects that occur from a sequence of investment returns.
In other words, the fact that each year’s return carries over to impact the balance being invested into the subsequent year means it’s not enough to merely add up the returns of each year and divide by how many there are, to determine the average rate of growth the portfolio actually experienced. Instead, the actual average return is somewhat lower, to account for the fact that there were both higher and lower returns that compounded along the way. This is known as the geometric mean or the geometric average return.
The following table illustrates this:
The difference created between arithmetic average returns versus the actual results experienced by the investor is also referred to as “volatility drag”. The greater the volatility in the return stream, the greater the variance will be between the “average” return and the actual portfolio’s measured return.
Subtract taxes and fees and it becomes easy to see why many investors fail to achieve their desired wealth goals.
Lessons for investors
The lessons for investors from all of this are:
- Investors need to think in terms of playing both offense (being in the market) and defense (protecting capital).
- Aside from cash, CDs and the like, no investment strategy is without the potential for losses. Given that the geometric return will ultimately determine the amount of spendable money accumulated, investors should strive for achieving consistent returns. Investment strategies that provide low drawdowns and more consistent returns will likely outperform strategies where there is a wide dispersion between annual returns.
- Investors should seek out strategies that are dynamic and that can rotate between offense and defense as necessary. The goal should be to maximize gains during optimal market periods and to protect capital during suboptimal periods.
Popular, traditional investment approaches that keep investors fully invested at all times fail to recognize both the nature of the markets and the mathematics of growing wealth.