Winning by not Losing

Given Matt Ryan has never lost a Super Bowl, it seems clear that he is putting together a superior career relative to Tom Brady, who has lost not one, but two Super Bowls. As a Boston College alumni, I want to enjoy the below #AlternativeFacts, though the inference is probably flawed. (But as a lifelong 49er fan, my childhood hero was a quarterback that truly won by not losing, but I digress.) While this “fact” is amusing and purposefully misleading, there is truth in the concept of “winning by not losing.”

nfltweet_blog

As an investor, there are at least two ways to “win by not losing”; avoiding large losses and controlling volatility. You have all likely seen the chart depicting the percentage gain needed to get back to even after suffering a given loss, but it’s important to understand, so I am going to show it to you again.

capitalgainsvsloss

If you think about the number of large drawdowns equity markets have gone through during the last 40 years, these are frightening numbers. After experiencing a 50% loss, an investor needs to earn 100% just to get back to even. For an even more extreme example, the Nasdaq Composite Index lost 78% from its 3/10/2000 high through its 10/09/2002 low. This means an investor in this Index would have needed to earn nearly 400% (or five times their remaining capital) to get back to even. It took the Index more than 12.5 years from its October 2002 bottom to once again reach its March 2000 high. Most investors don’t have the patience or the time to suffer many large losses; thus the importance of keeping losses at manageable levels.

A second, related, mechanism to win by not losing is to control volatility. The idea to minimize what is often referred to as “variance drain”.

expectedaveragereturn

The above table makes it very clear, volatility is extremely erosive to one’s wealth. The problems are clear, but how does one go about keeping losses manageable and volatility to a minimal level.

The key is diversification, the only real free lunch in finance. It is possible to combine investments with positive expected return and relatively high volatility on their own in a way that minimizes portfolio volatility while not degrading returns. The crucial task is to find investments that have low or negative correlation to each other, i.e., when some investments are doing poorly your other investments may be doing well, thereby smoothing out portfolio returns. When one does this properly they are well on their way avoiding large losses, minimizing volatility and thus “winning by not losing.”