By Marcel Roos, fund analyst at PSG Wealth.
Losses are an inescapable part of investing, but effective downside protection can help investors avoid big losses – which is a key aspect of long-term investment outperformance.
The graph below shows the future returns required to recover from a historical drawdown. As shown, the returns required to recover from drawdowns significantly increase as drawdowns deepen after a period of underperformance.
A small loss of 10% would need just 11% to recover, while a big loss of 50% would need 100% to recover. This illustrates the asymmetric nature of drawdowns. A percentage of excess return in a bear market is worth more than a percentage of excess return in a bull market.
Graph: Return required to recover after a drawdown
Retirees have the most to lose when it comes to drawdown risks as they have less time to recover from losses. In many cases, a drastic drawdown, coupled with continued withdrawals in retirement, can shorten the “lifespan” of your retirement funds considerably. Retirees need to work with their financial adviser to ensure they have adequate risk mitigation strategies in place.
Tools to protect against drawdowns
The primary tool in an investor’s toolkit to protect against drawdowns is diversification.
In theory, diversification is a relatively simple concept, but in practice it can be applied incorrectly. Common pitfalls include only focusing on the number of underlying investments without any regard for:
- concentration risk, sector and industry diversification
- geographical diversification
- asset class correlation, and
- investment manager diversification.
Perhaps the best way to view diversification is as a three-layer approach. The first layer consists of asset classes. Asset classes vary from equities, bonds, cash and property to alternative asset classes, both domestically and offshore. Asset classes tend to correlate less than perfectly, meaning that when one asset class performs poorly another asset class may perform less poorly or even favourably.
The second layer consists of different securities within the various asset classes. These securities may differ in terms of their sectors and industries, issuers or structure.
Performance of securities in different sectors differ based on the economic circumstances. Issuers and product structure play a role in the risk and subsequent prices of securities.
Particular care should be taken to ensure that the overall portfolio is not too concentrated in relatively few assets, or one or two assets that make up a disproportionately large chunk of the portfolio.
The third layer consists of investment manager diversification. Investment managers differ in terms of their investment styles, mandates and risk profiles. No single manager or investment style will always outperform the market, but by combining different managers, investors are less exposed to manager-specific risks, seeing as different investment managers and styles will outperform at various times.
If done correctly, this ultimately results in a smoother investment return profile without compromising on long-term outperformance.
Protecting against the downside helps to minimise the kind of upheavals that leave investors vulnerable to making emotional, rather than rational, financial decisions. A trusted and suitably qualified financial adviser can play a valuable part in helping investors curb the wealth-destroying impact of emotional behaviours, as well as assist in constructing suitably diversified portfolios.
This helps investors stay focused on their long-term goals and reduces the desire to switch between recent winners – a strategy that has been proven to erode investment value.