While the equity market has certainly had its ups and downs this past year, the trend has undoubtedly been to the upside. No matter how strong any of this year’s pullbacks have been, the broad market index has nonetheless responded by setting new record highs shortly after. Optimism - albeit with growing undertones of caution - resumes in relatively short order, brushing off the cause or strength of the reversals.
As we’ve noted many times in recent months, this ebb and ultimate flow higher continues to add to the ever growing Momentum risk that we feel may be under appreciated and perhaps not that well understood. While most of our discussion on the matter has focused on the systematic side, we wanted to provide perspective on the impact that a large, abrupt reversal could truly have on an investor’s portfolio.
Investors are, by their nature, optimists. Why else would anyone commit their capital to investments if they weren’t convinced it would grow over time? But while the optimism bias keeps money invested, downside protection is something all investors seek even more than growth. Loss aversion, one of the key tenets of behavioral finance, helps explain why. The desire to preserve capital is hardwired into our behavioral biases.
Numerous studies have shown that a $1 loss has a greater emotional impact on investors than a $1 gain. Yet the importance of downside protection, particularly as it pertains to helping meet long-term investment objectives, is still underappreciated by most investors, especially – it would seem - in today’s Momentum driven environment where many investors are over-exposed, intentionally or not.
Loss Aversion in a Portfolio Context
A simple exercise in mathematics helps provide perspective. Consider separate $100 investments in two stocks. At the end of one year, Stock A suffers an annual loss of 10%, creating a $90 balance, whereas stock B suffers a 50% loss, leaving a $50 balance. To recover from these losses and return to $100, Stock A only has to again about 11%, whereas stock B has to achieve a 100% return.
Apply this hypothetical scenario to today’s Momentum-driven market and the potential consequences of outsized losses become clear. When markets decline, the impact on high volatility stocks can be significantly higher, requiring a far greater recovery just to recoup losses. Figure 1 illustrates this point by providing a more incremental look at various degrees of drawdowns and the disproportionate returns needed just to “break even”. Over time, such higher bars to recovery can have significant implications for compound returns and delay investors’ asset growth.
Returning to Breaking-Even is not an Investment Objective
Keeping with our example of stocks A and B above, Figure 2 demonstrates what this really means for an investor’s portfolio. After Stock B’s 50% annual loss in year 1, let’s say it went on to have a 75% annual gain in year 2, making its average return for the two years 12.5%, which is pretty good under normal circumstances. But what about Stock A? After a 10% loss in year 1, let’s say it gains 25%, making its average return 7.5%, decent but only moderate when compare to Stock B.
But there is more to the story. Even though Stock B saw three times the gains as Stock A in year 2, Stock A outperformed during the two-year holding period to end nearly 30% higher. Why? Because the returns gained or lost during a given year of an investor’s portfolio are not isolated from the previous or following years. Indeed, investor portfolios don’t grow via average returns per year, they grow via compound returns over the years. How a portfolio performs in “year 1” is just as important as in “Year 2”, “Year 3”, and so on. So, while Stock A finished year 2 with only a 25% gain, it was 25% of a principal balance of $90, versus Stock B’s 75% increase from a principal balance of just $50. Which stock would you rather own?
Unfortunately, no investor is spared from these simple mathematical facts, or as we often call it; volatility drag. As noted above, volatility drag can have a profound impact on asset growth. It can be the difference between anyone in your client base being able to retire comfortably and on time – or neither. From retirees concerned about outliving their savings to plan sponsors attempting to match asset growth with longer-dated liabilities, large investment losses have the potential to derail any investor on their path towards achieving their stated objective. This is why our focus on protecting against the downside is such a critical component of our investment process and philosophy. To successfully grow assets over time, investors must first focus on protecting them.
The factors driving today’s ebb and flow of volatility are numerous, as are the systematic risks that have formed. Whether FAANG stocks continuing to claim a growing share of the broad market-cap weighted index, the on-going dominance of Momentum factors, or the Technology & Communications sector’s continued march toward Dotcom era weightings, the above should serve as a candid illustration of how crucial a well-balanced portfolio is in the current environment. We have never been shy about belaboring the point that risk-taking at this stage of the cycle needs to be intentional and more precise than ever, all part of a well-balanced approach that does not over-rely on only a few systematic-level trades.
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.
Past performance is no guarantee of future results.