INSIGHTS

While markets rise most of the time, downturns are an inevitable part of the investment journey. Having strategies in place to limit losses during these periods is just as important as benefitting from the strong returns on offer during more buoyant times.

Markets don’t move in a straight line

When it comes to investing, seeing the value of your portfolio increase over time provides a great sense of comfort. For some it means retirement plans are on track, while for others it provides us with security and lifestyle options.

When markets are going up, as has been the case for most of the past 15 years, we are naturally more open to taking on a little more risk to continue riding the wave of those higher returns. However, markets don’t rise in a straight line and 2022 has highlighted the reality of investing – that downturns and difficult markets are also part of the investment landscape.

When managing risk, insulating portfolios from these declines is a primary goal. It is during challenging periods that we find out what our true risk profile is, and when the value of protection strategies comes to the fore.

Minimising drawdowns in a declining market is often of greater importance to a portfolio’s long-term performance than capturing 100% of the market rallies.

The law of percentages

The importance of minimising losses relates to a simple but often overlooked fact – positive and negative returns are asymmetric. This means for every 1% decline in the value of your portfolio, you will need to see a recovery of more than 1% to get back to where you started. The greater the decline, the larger the rebound needs to be.

For example, if a $100 investment falls 10% to $90, then a gain of 11% is required to get back to $100. If the same investment fell 50% (from $100 to $50), a gain of 100% would be needed to get back to $100.

Strategies for protecting against market falls

One of the most effective (and cheapest strategies) is to simply hold a diversified portfolio across a range of asset classes, including cash and fixed income.

Assets classes perform differently depending on the economic backdrop, and a diversified strategy helps insulate portfolios from the more volatile moves in equity markets.

Regular rebalancing of your portfolio back to target allocations is another simply yet powerful tool when it comes to protecting portfolios from severe market declines.

Rebalancing helps to ensure that your asset allocation doesn’t stray too far from the level of risk you are comfortable with.

It also helps to overcome a number of key psychological hurdles when it comes to investing including; 1) chasing investment returns and trends, 2) impulsive decision making, and 3) trying to time the market.

Both strategies involve a cost – an exposure to more conservative assets means you won’t do as well during strong markets, while rebalancing can mean you don’t let your winners run. Nevertheless, the value of minimising downside is difficult to dispute.

Investing is a long-game and minimising losses is key to consistent long-term returns

Using the global financial crisis (GFC) as an example, we compare the performance of the Craigs balanced portfolio (which typically has a 60% exposure to equities) against a 100% equities portfolio.

While the 16-month drawdown period from the peak in October 2007 to the trough in March 2009 was the same for the two strategies, the 17% decline in the balanced portfolio was half that of the 100% equities portfolio (-38%).

To get back to post GFC levels, the 100% equities portfolio would need to rise 61%. This compares with a rise of 20% for the balanced portfolio.

Despite the strong rally seen across equity markets following the GFC, it took the 100% equity portfolio 47 months to surpass its previous high. The balanced portfolio recaptured its previous highs in less than half that time (22 months).

The moral of the story is straightforward - having strategies in place to limit losses during difficult periods is just as important as benefitting from the strong returns on offer during more buoyant times.

Broad diversification, regular rebalancing and a generally defensive approach are all excellent strategies for investors to limit downside during volatile markets and enjoy superior long-term returns.