Significant losses are hard to recoup.
A 40% portfolio loss requires a 67% return to see a complete recovery. Lesser drawdowns may mean a faster recovery after down markets, putting investors in a potentially better position to compound returns over time.
The Importance of Downside Protection to Help Harness Long-Term Returns
Most investors will tell you that their goal when investing is to achieve strong returns while minimizing risk. When the markets go through a long advance, such as the bull market of 2009-2020, there is a natural tendency to focus more on the “strong return” part of that goal than on minimizing risk. But what successful investors know, and anybody who experienced the extreme market volatility of 2020 knows, is that to get there faster, downside protection strategies—or techniques used by an investment manager to prevent a decrease in the value of an investment—can reduce the frequency and magnitude of losses in investors’ portfolios.
It’s important to remember that large losses require even larger gains for a portfolio to recover fully. The larger the losses, the disproportionately greater the size of the percentage gains required to make up for those losses. It’s in the math.
For example, as the chart shows, a 50% portfolio loss requires a 100% return to see a complete recovery. This means plenty of catching up is necessary to get back to the original starting point as principal has shrunk; this can be of significant concern to investors who have an investment horizon that is shorter than the time needed to recover.
Lesser drawdowns may mean a faster recovery after down markets, putting clients in a potentially better position to compound returns over time. The idea behind compounding is that income and earnings generated by a portfolio, when reinvested, will generate even more income and earnings, such that investors can grow their investments more quickly over time. The less an investor loses in a portfolio, the less time the portfolio needs to recover, which means there’s more time for the portfolio to compound returns and grow an investor’s investments. The chart below illustrates this point. The light green line represents a portfolio that participates in 100% of the gains and losses of the Russell 3000® Index. The dark blue line shows a portfolio that captures 90% of the index’s gains and 75% of its losses. Over the past twenty years, investing in this portfolio would have better positioned investors to reach their long-term goals.
The Upside of Active Management for Downside Protection
The ability for a manager to consistently demonstrate a repeatable process that protects capital on the downside is gaining importance as time periods between major market downturns are getting shorter, making a manager with a consistent downside protection strategy more valuable now than ever. Many investors are tempted to sell riskier assets after steep market declines. Portfolios that provide strong downside protection may help investors stay the course and avoid this temptation.
No manager, active or passive, could have predicted the global pandemic in 2020. However, active managers who do their own research and pick each company they invest in with care and purpose can be prepared regardless of whatever market events may transpire. In contrast, passive strategies such as ETFs and index funds, many of which mirror indices, are subject to the whims of the market. At SBH, our investment processes are designed to help protect capital through turbulent markets and over the long term.
For more information on SBH’s downside protection strategy, please contact us at (800) 836-4265 or email us at contactus@sbhic.com.
The opinions expressed are solely the opinions of Segall Bryant & Hamill. You should not treat any opinion in this material as specific inducement to make a particular investment or follow a particular strategy, but only as an expression of the manager’s opinions. The opinions expressed in this material are based upon information the manager considers reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this material can be does not constitute financial, legal, tax, or other professional advice and is not intended as a substitute for consultation with a qualified professional. The manager’s opinions are statements are subject to change without notice and Segall Bryant & Hamill is not obligated to update or correct any information in this material. For illustrative purposes only.