From the October 2017 issue of Research Magazine • Subscribe!

Navigating Uncertain Rewards and Certain Risks

When times and markets are good, it's easy to be complacent and lose discipline

September 1, 2011, was a beautiful day. Photographer Gary Elliot was taking pictures at Swami's, a popular surfing beach in Encinitas, California. The surf was high that day, but nothing else seemed out of the ordinary.

When reviewing his photographs later, Elliot noticed a large shark fin in a cresting wave near several surfers. There had been no reports of sharks. As confirmed later by experts, the size and shape of the fin indicated a great white shark, about 12 feet long and weighing roughly 1,000 pounds.

This remarkable happenstance is a powerful metaphor for investing in stocks. Equity investing offers uncertain rewards but certain risks, no matter how beautiful the weather or how calm the seas. These risks are often opaque to us. There is no way to know if and when those risks will bite and what the extent of the damage will be.

Yet investing in stocks is crucial for investors to reach their financial goals because of the returns they provide. Risk and reward are inherently connected. Suppose, for example, back in 1928 you had invested in stocks (the S&P 500), bonds (10-year U.S. Treasury notes) and cash (three-month U.S. Treasury bills) and held on through the end of 2016.

Over that period, stocks averaged 11.42% annual return, bonds 5.18% and cash 3.46%. In other words, if you had invested $100 in each of those categories, at the end of 2016 you would have had $1,988 in the cash account, $7,110.65 in the bond account and an astonishing $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 investment returns.

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 allowed 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.

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