Increasingly, we’ve been thinking about the way that investors view risk in the planning stages, as opposed to how they experience risk in real time. And no surprise, there is a not-so-insignificant delta between those perspectives. The problem lies in the fact that whether running forward-looking simulations, or drawing conclusions from historical data, both the likelihood of a loss, and the size of the potential loss that an investor could experience over the full investment horizon will appear to have been underestimated when viewed on a continuous basis with hindsight.
That is a bit of a mouthful, so let’s unpack that.
Almost all risk and return statistics used in the investment industry, at least those for public consumption, are based on monthly returns. And, when you use monthly returns to calculate a statistic-like drawdown, there is a high probability that the apparent drawdown will be less severe than if you were to calculate it using daily returns. Of course, the actual drawdown is the one based on daily returns. That is what investors live through; they couldn’t care less what the drawdown may happen to look like after the fact when monthly returns are used to calculate the pain they felt in the moment.
The same is true when running simulations over say a five, seven, or 10-year horizon, as is common in the investment planning stages. The probability of a loss and the size of that loss over the entire time period from point A to point B is lower than when measured on a continuous basis. In other words, in order to “achieve” a 10% loss, an investor may have to stomach a 25% loss along the way. Mark Kritzman at Windham Capital Management has written extensively about this over the years, and likely does a better job of explaining it, so we’ll let him do so.
“End-of-horizon estimates of exposure to loss drastically understate a portfolio’s vulnerability to losses along the way. The moderate investor has only about a 1% chance of losing 10% or more at the end of five years, but there is a 15% chance that the portfolio will depreciate by at least that amount at some point along the way, and it increases to 36% if we expect a turbulent period to prevail. These are huge differences.” – Windham Capital Management
With that knowledge in hand, at a minimum, the nature of the conversation with the client should change to ensure that the true potential for loss along the way is understood. However, since we know that there is a world of difference between being able to comprehend this issue intellectually, and actually being able to handle it emotionally in the moment, we’d suggest that you build portfolios that address the issue directly. It is, after all, the destination and not the journey that matters to investors, but if they stop climbing for fear of heights, they can’t reach the summit.