INVESTMENT PLANNING AND RISK: AVOIDING KEY PITFALLS

“Thinking risk control is easy is perhaps the greatest trap in investing, since excessive confidence that they have risk under control can make investors do very risky things. Thus the key prerequisites for risk control also include humility, lack of hubris, and knowing what you don’t know.” ~ Howard Marks, Chairman of Oaktree Capital

Few things destroy a person’s long-term investment strategy more than a misunderstanding about the long-term relationship between expected return and risk. No matter how enticing an anticipated return, nothing is more important than avoiding the possibility of permanent loss.

My mission is to help people avoid the hidden pitfalls in the investment process and achieve a successful long-term outcome. Above all else, I believe my job is to help investors understand that there are investment approaches that can dramatically reduce risk without a reduction in the potential for long-term returns.

This paper will reveal three of the most dangerous mistakes an investor can make:

  • Not understanding and underestimating risk
  • Looking at only one benchmark (or measure) of success
  • Letting short-term expectations and frustration destroy long-term plans

Recent historical returns and volatility can be calculated with decimal point precision. However, risk is different from volatility and can’t be calculated in advance. Nevertheless, a great deal can be learnt about how to steer clear of major pitfalls.

Here is a summary of what I intend to cover:

  • Why Wall Street benchmarks are too volatile for most people, especially those who are nearing retirement
  • What benchmarks are most appropriate for long term success
  • How short-term expectations and frustrations can destroy long-term plans
  • How understanding one ratio could materially lower your risk of permanent loss
  • Show how systemic investment approaches can significantly improve an investment plan

Wall Street benchmarks are too volatile for most investment plans

Most investors tend to default to what the Dow and S&P 500 have been doing recently and compare this with their own portfolio. But once this is examined more closely, it becomes clear that these are extremely poor benchmarks, particularly at the current time. Here’s why:

First, the volatility of the S&P 500 makes it inappropriate for most investment plans. In the last 15 years the S&P 500 has had two massive drawdowns (peak to trough potential loss periods): one around 48%, from 2000 to 2003 and another around 53% from 2007 to 2009. This means that many people lost virtually half of their investment! Not many investors can afford a loss of this size and bounce back.

Second, big cap US stock indices are a poor benchmark because the current 10-year expected return on the S&P500 is around zero (http://www.hussmanfunds.com/wmc/wmc140728.htm), and for all shorter periods it is negative. Most of the signs seen at the peaks of 2000 and 2007 have returned. Why should anyone expect a different outcome than experienced in 2008?  Many of the best investors are currently at high levels of caution. Warren Buffet has $55 billion in cash. George Soros has a substantial put option position (which profits from a down market) on the S&P 500. GMO Fund Management, who manage over $100 bn of assets, expect a negative 7-year return on US equities. Wise investors are taking protective measures.

These points are particularly important for investors who are near or already in retirement since their portfolios are generally their largest source of sustained income – a major loss would put them in real jeopardy. In addition, the emotional strain of too much volatility has both mental and health consequences to consider. There simply are much more appropriate benchmarks.

Appropriate Sustainable Benchmarks

Choosing an appropriate investment measurement is a foundational step in producing a successful long-term investment plan. Investors with conventional asset allocations and who rely on Wall Street benchmarks may be in for a tough few years.

One of the greatest pitfalls of investing is looking only for returns without fully analyzing the true potential for loss. Risk is the crucial additional component that always needs to be fully considered. Without understanding risk, investors take an enormous chance of being unable to sustain their investments over time. The problem is that many people simply do not know how to make a wise comparison between their portfolio returns and what are common but inappropriate benchmarks.

How short-term expectations and frustrations can destroy long-term plans

Unless an investor can come to terms with an appropriate investment benchmark and embrace it, sooner or later it will lead to frustration and potentially erratic and damaging decisions. Chopping and changing at the wrong moment is probably why the average investor has very poor long-term results.

Frustration is understandable when things don’t turn out as well as expected or planned. But, this frustration can be largely eliminated by clarifying one’s expectations and by accepting, ahead of time, the very real possibility that there may be short-term lags in order to achieve long-term gains.

If you are a long-term trader or investor, then it is probably best to limit any expectations about what the market will do over the weeks immediately ahead. Successful traders and investors understand risk and acknowledge the possibility that they will often be wrong. However, because they structure their portfolios so well, being wrong about any particular idea or strategy won’t be financially devastating. They never lose more than they can afford in order to maintain capital.

The truth is there will always be some index that seems to outperform in the short-term. But you can avoid the pitfall of chasing short-term gains by sticking with your long-term plan. Just remember your goal of long-term high returns, systemically achieved.

Risk control may restrain results …. But it will also extend an investment career and increase the likelihood of long term success.”

Howard Marks, Chairman of Oaktree Capital

Understanding the essential Return-To-Volatility Ratio

A successful investment plan can only really be achieved by examining not just long-term returns, but also long-term volatility. Both these factors, together, provide the most useful basis for creating a sustainable and appropriate benchmark. What investors really need is an analysis and understanding of the relative benefits of the long term return-to-volatility ratio of different investment strategies.

The table below shows how various investment strategies have fared for over 40 years (1970 to 2012), a period that covers all kinds of market conditions.

(See the links in http://chrisbelchamber.com/cb1/mn/mn85.asp, which cover the analysis in much greater detail).

Strategy Average
Return
Sharpe
Ratio Return/Vol
Largest
Drawdown
Total US Stock Market 9.61% 0.57 53.48%
60% stocks, 40% Treasuries 9.67& 0.93 30.18%
All Weather (25% in each of US stocks, cash, gold, stocks) 8.55% 1.25 17.82%

Note that for only a small reduction in return, the All Weather approach has vastly better volatility and risk metrics across the spectrum.

The Sharpe Ratio, which is the second column, is a widely used key measure of the long-term average return-to-volatility ratio. It essentially shows that the All Weather approach achieves more than twice the return per unit of risk than the total US stock market. Putting this another way, for the same return it has less than half the risk.

The third column shows another simple risk metric. The largest drawdown is the largest potential loss before the market makes a new high. Once again the All Weather system shows that its biggest account value loss over the entire period was less than a third of the loss for US equities. Over a 42 year period, investing solely in US equities meant having 3 times the potential for loss than an investment in the All Weather system.

All Weather Allocation and adaptations for higher returns

There is flexibility within the All Weather system as regards security selection, but there are also substantial additional improvements possible and other systemic approaches that can be mixed in. One excellent example is to consider how an Adaptive Allocation Strategy could be mixed with the All Weather approach. Here is a link for further examination: http://www.advisorperspectives.com/dshort/guest/BP-120514-Adaptive-Asset-Allocation.php

All this is to illustrate that the All Weather system is just a starting point for a complete portfolio strategy, which is highly likely to further improve long-term Return/Risk metrics. In practice, it is likely that a combination of these strategies will provide the most optimal outcome. With constant application this approach can be seen to have the potential to both lower risk and increase return!

This is a new way of thinking for most investors and is not widely understood even among many investment professionals. However, it is a central approach that has been employed for decades with substantial success in a number of highly successful funds. The one mutual fund that adopts a similar approach, the Permanent Portfolio (PRPFX) has an unmatched record over the last 32 years. It has half the volatility of the S&P 500, and yet has outperformed this benchmark by over 4% on average over this period. How many funds can say that over the very long-term? How many funds even last for that period of time?

Most importantly, the All Weather allocation was highly effective through the 2000 and 2007 bubble periods as is clearly shown in the returns of PRPFX through those periods. This is especially the time to employ these systematic approaches given the similarity of current valuation levels compared to those periods.

Conclusion

Since the media focuses heavily on the big cap indices, many investors have come to think of the Dow and the S&P 500 as broadly definitive in all forms of investment outcome. Certainly, they do have their usefulness as benchmarks amongst many others. However, they are also clearly an inappropriate basis and measure for a long-term investment plan. This confusion can create considerable problems for investors which puts their whole investment process at unnecessary risk.

This all stems from a deeply flawed premise: that the S&P 500 benchmark is an appropriate gauge of an investor’s long-term investment plan. A 40% fall is devastating, and the S&P 500 has fallen further than this twice in the last 15 years.  Using an inappropriate measure of your long-term performance ends up having many adverse consequences. And it creates unnecessary anxiety as investors begin to constantly worry about even short-term erratic moves in the S&P 500.

Investors deserve a better basis for their investment plan, one that substantially improves the efficiency and consistency of their returns and offers more certainty in their investment outcomes. Once investors embrace a better strategy and benchmark, everything changes: they have much less to worry about (as they are now operating in a far more stable set of circumstances), with far less chance of a material failure of their investment plan. They can then also begin to pay less attention to what the S&P 500 does each day, and rest easy knowing that their long-term strategy is more stable and sustainable, without any overall change in their potential for long-term returns.