$326,645.87 in the stock account — over
that period, stocks earned 165 times more
than cash and 46 times more than bonds.
Risks & Returns
Unfortunately, however, that enormous
benefit comes with drawdown risk. Stocks
suffered enormous losses of more than
20% six times between 1928 and 2016,
and in 23 of 89 years — roughly one in
four — provided negative returns.
That unfortunate reality causes investors of all sorts to make bad decisions
(performance chasing, buying when
markets are high, selling when markets
are low, etc.) such that investor returns
over time are dramatically lower that
Many people claim to be long-term
investors. Very few really are.
Some investors react to drawdown risk
by hoping to buy stocks that only go up.
Those stocks do not exist. For example,
most people would cite Amazon as exactly the type of stock they want to own. A
$10,000 investment into Amazon shares
purchased at its initial public offering in
1997 is worth roughly $5 million today,
far better than market returns.
However, Amazon shares have seen
daily declines of 6% or more 199 (!)
times, have fallen 15% over a three-day
span on 107 different occasions and have
suffered at least 20% pullbacks in 16 of
its 20 years of public trading. The drawdown risks have been immense.
Other investors react to drawdown risks
by insisting that the right approach or the
right manager can avoid them somehow.
That is a fool’s errand, too.
Most experts would agree that Warren
Buffett is perhaps the best investor of all
time. The most recent data from Buffett’s
firm, Berkshire Hathaway, shows 20.8%
in annual returns to investors from 1965-
2016 (over 50 years!), more than double
that of the S&P 500.
However, as I have noted before, Buffett still underperformed over half the
time and suffered some huge drawdowns.
Roughly, every six to seven years on average, Buffett has taken a big loss.
What to Do
The best advice most of the time is to accept that drawdown risk is the price paid
for the returns stocks provide as compared
with bonds and cash. Other possible investments, despite the latest financial
engineering techniques, cannot measure
up in performance either. For example,
when analyzed on an asset-weighted basis, as Simon Lack has documented, if all
the money that has ever been invested in
hedge funds had been invested in U.S.
Treasury bills instead, the overall results
would have been twice as good.
When times and markets are good— and
they have been very, very good — it is easy
to be complacent and lose discipline. We
can over-allocate to markets and sectors
that are doing especially well. We can neglect rebalancing. We can expect the good
times to continue indefinitely. After a stock
market rally that is now into its ninth year
and despite the power and importance of
stocks, some portfolio adjustments may
be in order today. Some examples follow:
1. In a great market environment, it
is easy to see stocks as the answer to every possible question. However, the long
stock market rally may have allo wed some
investors to exceed their financial goals.
Those who have won the game do not
need to play anymore. At a minimum,
they can take some risk off the table and
protect their victory.
2. The current bull market has caused
many portfolios to become unbalanced
such that the commitment to stocks
now well exceeds the original allocation
percentages. These portfolios should be
rebalanced to comport with clients’ risk
tolerance, capacity and need.
3. Even the strongest buy-and-hold
advocates should be willing to adjust their
asset allocations in the face of changing
market valuations by selling off assets when
their future return expectations are low.
This “overbalancing” strategy is a step-up
from normal rebalancing — not just pruning the over-performing asset to a target
allocation, but cutting it back still more.
4. Those at or near retirement (before
and after) face unique risks. Sequence risk
relates to drawdown risk and the order
in which returns on retirees’ investments
occur. Essentially, when drawing income
from a portfolio, low or negative returns
during the early years of retirement will
have a greater impact upon overall success rates than if those negative or low
returns occurred later, even if the overall
average return is the same.
If poor returns and ongoing withdrawals deplete a portfolio before the “good”
returns finally show up, financial disaster can and does occur. Taking risk off
the table during this period and/or committing to a guaranteed income vehicle
mitigates sequence risk dramatically.
Investment outcomes and risks are
inherently uncertain, yet we still have
some control over the consequences of
what happens. Dealing with inherent uncertainty is the essence of risk management. The current, long bull market may
have lulled investors into a false sense of
security, thinking that there are no risks
lurking beneath the surface. Smart investors will prepare for inevitable drawdowns
before they happen. Reality may bite, but
it need not eat you.
Bob Seawright is the chief investment and
information officer for Madison Avenue
Securities in San Diego. He is active on Twitter,
@RPSeawright, and his blog “Above the Market”
can be found at rpseawright.wordpress.com.
Other investors react
to drawdown risks by
insisting that the right
approach or the right
manager can avoid
them somehow. That
is a fool’s errand, too.
ABOVE THE MARKET