• Now is a good time to review strategies for improving overall portfolio efficiency and reducing or truncating downside risk.
  • There are several strategies that are particularly well-suited for truncating downside risk.
  • The third quarter reminds us that thinking about stability and resilience can be just as important as thinking about opportunity and profit.
  • The third quarter of 2015 was no fun. Having been spoiled by six years of steady gains across all kinds of financial assets, we might regard the recent episode of market volatility as a rude intrusion upon our ongoing right to steadily increasing account values. Of course, it doesn’t work that way. Volatility in both directions comes with the territory for long-term investors. Indeed, in some academic circles the belief is held tightly that it is volatility, and only volatility, that entitles us to earn any return at all on our investments. Our willingness to endure the ebbs and flows of wealth over time, to put our capital at real risk, earns our ultimate compensation.

    Whenever markets provide uncomfortable reminders that drawdowns are inevitable in investing, I find it helpful to focus on the important arithmetic of compound returns. A quick exercise will illustrate the point. Exhibit 1 shows the total return for a sampling of asset classes during the third quarter. Losses were widespread during the quarter, and quite severe in some cases.

    Exhibit 1: Total return Q3 2015
    Exhibit 1: Total return Q3 2015
    Source: Bloomberg, 10/15

    The exercise proceeds as follows. Let’s do the math to figure out the positive return required for each asset class to reclaim a flat cumulative return. For example, the EAFE index fell by 10.2%. Had you invested $100 in the index on June 30, that investment would be worth $89.80. A return to $100 would require a gain of 11.4% {solve for x ->89.80(1+x)=100}. Repeating this exercise for all of the asset classes in Exhibit 1, we can create Exhibit 2 below.

    Exhibit 2: Total return required to recover Q3 drawdown
    Exhibit 2: Total return required to recover Q3 drawdown
    Source: Bloomberg, 10/15

    Looking carefully at the two charts provides three key insights. First, in every case, the absolute size of the gain required to offset the third quarter drawdown is higher, in percentage terms, than the drawdown itself. Second, clearly the gains required to recover are more readily achievable the smaller the drawdown is in the first place. Finally, the ratio of required gain to original drawdown increases with the size of the drawdown. Each of these observations is important when we think about the process for accumulating wealth across the combination of a down market and an up market. A big drawdown makes it very hard to keep up over the period encompassing both a drawdown and subsequent recovery. For example, from Exhibit 2 we can easily see that a 20% rally for emerging market equity will still leave an investor underwater, while a 6% gain in high yield will return an investor to profitability. Cumulative return is not just about making high returns when markets are going up. It is also about keeping drawdowns low, proportionally, during weak markets. A straight up market tempts us to forsake this principle in an effort to get in on the action. In a two-way market like the one investors face today, it pays to mind our downside risk.

    Using these insights, we can contemplate investment strategy at a deeper level. Accepting the inevitability of episodic drawdowns, especially in an environment where most assets are quite fully priced, investors could review strategies for improving overall portfolio efficiency and reducing or truncating downside risk. Portfolio efficiency refers to the expected return per unit of risk of a portfolio. If we can reduce risk without sacrificing return, or add return without expanding risk, we unequivocally improve portfolio efficiency. Diversification is the one demonstrable way to accomplish that improvement, and we believe that most portfolios could be better diversified by either introducing new holdings with a differentiated performance profile than existing holdings (like alternatives) or by rebalancing existing holdings with an eye towards balancing risk allocations. Distributing risks more evenly can produce a more pronounced diversification benefit, and improve portfolio efficiency.

    Truncating downside risk is challenging lately, as diversification alone has been weakened by heightened commonality across traditional assets. Beyond diversification, investors can still embrace several strategies that are particularly well-suited for truncating downside risk. For example, our asset allocation recommendations have recently featured an increase in recommended cash allocations for exactly this purpose. Cash will not produce a high return, of course, but neither will it lose value in a down market. Incorporating a proactive strategy for reducing portfolio risk under certain conditions is another way of addressing downside risk. After six years of uninterrupted gains, taking some profits in a disciplined fashion can be useful to reducing downside risk. Finally, explicit hedging strategies cost money, but can be useful in improving downside resiliency.

    It is natural to think about opportunity and profit. The quarter just ended reminds us that it can be just as important to think about stability and resilience.

    © Columbia Threadneedle Investments

© Columbia Threadneedle Investments

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