You invest Rs 100.
Let’s consider the following sequence of returns.
Case 1: You earn -50% (or lose 50%) in the first year. You earn +50% in the second year.
Case 2: You earn -25% (or lose 25%) in the first year. You earn +25% in the second year.
Case 3: You earn -15% (or lose 15%) in the first year. You earn +15% in the second year.
Case 4: You earn -5% (or lose 5%) in the first year. You earn +5% in the second year.
Let’s reverse the sequences.
Case 5: You earn +50% in the first year. You earn -50% (or lose 50%) in the second year.
Case 6: You earn +25% in the first year. You earn -25% (or lose 25%) in the second year.
In which case, do you think you will fare the best or end with the highest amount at the end of the second year?
Will you have Rs 100 at the end of the second year because you gained back (in percentage terms) what you lost in the first year or vice versa.
Case 1: You start with Rs 100. At the end of the first year, you will have Rs 50 (50% loss). At the end of the second year, you will have Rs 75 (50% gain over Rs 50). As you can see, you have still not broken even. Once you have seen a drawdown of 50%, you need to make 100% just to break even.
Case 2: -25%, +25%: You end up with Rs 93.75
Case 3: -15%. +15%. You end up with Rs 97.75
Case 4: -5%, +5%: You end up with Rs 99.75
Case 5: 50%, -50%: You end up with Rs 75
Case 6: 25%, -25%: You end up with Rs 93.75
In all the cases, we end up with some loss of principal.
Do note, for cases 5 and 6, where the sequence of returns is reversed, there is no difference in the final outcome. However, this is only because we invested lumpsum. If your investments were split over a period, the sequence of returns will affect the outcome. In such a case, you are better off earning good returns later.
What does this tell us?
While making good returns is important, avoiding big losses is just as important for long term investment performance. If you keep losing big, the odds of investment success won’t be in your favour.
As we can saw in case 1 (-50%,50%), even though the arithmetic mean of the returns is zero, you are still down 25% of the end of the second year. For you to break even, the sequence should have been (-50%, 100%). Not easy.
Almost all the portfolios do well when the markets are rising. For long term performance, what matters is how your portfolio performs when the markets are not doing well. In my opinion, consistent downside protection is a primary source of alpha (excess return) for portfolio managers.
Many investors focus on short-term performance while selecting their investments. What if the short-term performance came on the back of really bad performance in the year prior? Therefore, short-term performance (good or bad) can be misleading. You need to focus on long-term performance while selecting your investments. You can also look at rolling returns and downside protection while selecting mutual fund investments.
By the way, losing less does not just help you with investment performance. It can help with investment discipline too. You are more likely to stick with an investment strategy that does not test your nerves too often. Do note, when it comes to investments, investment discipline plays as important a role as your skill of picking the right investments. When you are losing money, it is easy to lose hope and exit the investment (perhaps at the wrong time). This happens with many retail investors (like you and me) all the time.
What can you do to avoid big losses?
The simplest way is not make safe investments but let’s not get into that option. I assume we want to embrace volatility in search of better returns.
There are many exotic ways to avoid big losses. You can buy put options. Many financial institutions regularly come out with fancy products for downside protection. However, you can reduce the major drawdowns in the portfolio through the common-sense approach of portfolio diversification.
Do note, diversification cannot eliminate drawdowns (losses). It can only reduce the impact.
Diversify (mutual funds in place of stocks)
While I am not asking you not to invest in direct equity, you must avoid having very concentrated portfolios. Having all your wealth in just 3-4 stocks can be tricky for most investors. Have more stocks in your portfolio (but not too many).
One simple way to achieve this is to invest in equities through mutual funds. The way mutual funds work, you will have a more diversified investment portfolio.
In fact, you can own both direct equity and mutual funds in your equity portfolio. Let’s say you have 50% of your equity portfolio in stocks and the remaining in mutual funds.
Diversify across asset classes
We talked about diversifying equity investments in the previous point. However, that is not true diversification. If all your money is in equity or even diversified equity mutual funds, you will still suffer heavy losses if the markets were to more down sharply. Holding 5 small-cap funds is not diversification.
You need to split your investments across uncorrelated assets or assets with low correlation. For instance, you can divide your wealth across equity (domestic/international), debt, gold and real estate. The exact allocation will depend on your comfort with the asset, volatility and the investment objective.
Many investors spend a lot of time figuring out the best mutual fund to invest in. Nothing wrong with the approach but the baton of the best fund (historical performance) keeps passing. In my opinion, you are better off sticking with a good fund (may not be the best), keep an eye on the asset allocation and rebalance your portfolio at regular intervals. This is a much easier and reliable approach as compared to finding the best mutual fund.
Where do you think you will fare better if the equity markets were to go down sharply?
- You have 90% of your wealth in the best performing mutual funds (assume you can find one).
- You have 50% of your wealth in the average performing funds and the remaining 50% in the bank fixed deposits.
In most cases, the second option will yield better results.
Diversification across asset classes is the simplest and the best way to prevent big portfolio losses. When the times are good, you may not find diversification worthwhile. You will not find merit in diversification when your equity investments are returning +20% in a year. You will find merit when your equity investments return -20% in the year. Over the long term, diversification will eventually prove its worth. Diversification won’t just reduce volatility in your portfolio. When combined effectively with regular rebalancing, it can provide you higher returns too.