Humans seem hard-wired to emphasize offensive gains—both in investing and sports. Basketball games are remembered by fast-break slam dunks, not the steals that create them. Investing is no different. Bull markets command attention causing investors to focus more on the gains in their portfolios, and less on the portfolio’s ability to protect, in the event of a market drawdown.
Investors often forget the understated—but crucial—role protection from market drawdowns plays in determining long-term outcomes. Yet the ability to pare back losses during the inevitable downturns that come with investing, actually matters more to the end goal than eking out every bit of a bull market’s gains.
As 2020 has shown so far, the importance of mitigating loss is worth remembering. This article details why goal-oriented investors should place more emphasis on playing defense and minimizing drawdowns to their portfolio.
A Long Way Down, an Even Longer Crawl Back
Bear markets are unavoidable for anyone investing over the long haul. How a portfolio weathers those downturns has a critical impact on the investor’s end destination. This is because steep market drops create large holes from which to dig out. As the loss grows, so too does the return needed just to get back to the original, pre-downturn starting point. Consider the math: A loss of 10% requires just an 11% gain to recover, while a 50% loss requires a 100% gain to recover and a 60% loss requires an even more daunting 150% gain to simply return to even.
The chart below demonstrates how important it is to limit drawdowns, and shows that minimizing loss may be more important than fully participating in the market’s gains.
The blue line represents the performance of the S&P 500 Index. It shows where a portfolio would end if it participated in 100% of the market’s gains, but also took full part in its losses.
The orange line represents a portfolio that participated in 60% of the S&P 500’s gains, but experienced only 40% of the S&P 500’s downside during market declines. Over time, investors would be much closer to reaching their investment goals with the more defensive approach.
Recovery Time Matters for Most Investors
Recovering from a drawdown is even more daunting when one considers the time it takes to get back to the starting line after a large loss. The chart below shows the time to recover after a 20% market drop under different performance scenarios. For young investors just starting out, the time to recovery is perhaps less concerning. Not so for their older counterparts, however. Older, and even middle-aged investors, must carefully consider drawdown risk to avoid large losses as they near retirement.
No Time to Lose
Investors may not have time to rebound from significant losses.
Large Drawdowns Have Psychological Impacts
As the first chart shows, minimizing drawdowns has a bigger effect on long-term returns than capturing all the market’s upside. The chart doesn’t account for investor behavior after large losses, however. That behavior may amplify the drawdown’s impact.
Large losses can scare investors and push them to the sidelines at precisely the wrong time, causing them to miss the market’s rebound. If losses are less severe, it can keep the investor on track with their allocation to equities that is needed to meet their long-term goals.
Long/Short Equity Strategies Help Play Better Defense
Investors can make their portfolios more defensive by adding strategies that experience smaller drawdowns during severe downturns. Long/short equity strategies may offer a unique way to achieve that goal, because they help minimize drawdown but still allow clients to participate in equity markets’ upside. By going long, the strategies gain ground when markets rise but, as the chart below shows, historically long/short equity strategies had experienced much smaller losses in bear markets than a typical long-only strategy.
In an offensively-minded world, the importance of a good defense is easy to overlook. But strategies that minimize drawdown play an important role within all client portfolios. Lesser drawdowns mean an easier and quicker recovery after down markets— potentially leaving your clients in a better position to compound returns when things bounce back. Minimizing drawdowns can also discourage some of the behavioral mistakes often associated with bear markets, such as running to the sidelines and missing an equity market rebound.
As your clients near retirement, they will be unlikely to remember their portfolios’ performance during a bear market while they’re enjoying the post-game celebration. However, you can be confident knowing the unsung heroes played their part when it was needed most.