Downside protection. It’s something all investors seek. Loss aversion, one of the key tenets of behavioral finance, helps explains why. The desire to preserve capital is hardwired into our behavioral biases. In fact, 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, especially as it pertains to helping to meet long-term investment objectives, is still underappreciated by most investors.
A simple exercise in mathematics provides 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. Alternatively, stock B suffers a 50% loss, leaving a $50 balance. To recover from these losses and reach $100, Stock A only has to return ~11% whereas stock B has to achieve a 100% return.
Apply this hypothetical scenario to security selection and the potential consequences of outsized losses become clear. When markets decline, the impact on high volatility stocks can be significantly greater, requiring a much larger recovery to recoup losses. Over long periods of time, this longer time to recovery can have significant implications for compound returns.
As Figure 1 below shows, from January 1, 1997 to December 31, 2015, stocks with the highest volatility in the Russell 1000 Index posted significantly lower geometric returns versus stocks with the lowest volatility. So what exactly does this mean and why should investors care? Before we answer that question, here is a quick refresher on “average” versus “geometric” returns. Average returns assume that each percentage return in a data set is an independent event. However, when it comes to wealth creation and preservation, we know this is not the case. How a portfolio performs in year 1 is just as important as how it performs in year 2 and year 3, and so on.
Figure 1. Low Vol vs. High Vol: Compounded Returns for High-Volatility Stocks Have Been Dramatically Lower
Source: Russell Investments, Voya Investment Management. Data is for the Russell 1000 Index for the time period January 1, 1997 to December 31, 2015.
Figure 2 demonstrates this point using our example of Stock A versus Stock B above. 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. This would make Stock B’s average return for the 2 years 12.5%. This can be considered pretty good. And how did Stock A do in year 2? Well, after a 10% loss in year 1, let’s say Stock A gains 25%. This would make Stock A’s average return 7.5%, which can be viewed as perfectly respectable until you compare it to the 12.5% average return for Stock B. But does this tell the whole story? Of course not. Stock A’s 25% gain in year 2 is applied to a principal balance of $90, whereas Stock B’s 75% gain is applied to a principal balance of just $50. So at the end of year 2, a $100 investment in Stock A is worth $112.50, while a $100 investment in Stock B is only worth $87.50. Which stock would you rather own?
Figure 2. Larger Investment Losses Require Significantly Higher Returns to “Break Even”
Source: Voya Investment Management (hypothetical example intended for illustration purposes only).
The calculation for geometric (i.e. compounded) returns, on the other hand, takes into account the value of each data point that came before it. Accordingly, the use of geometric returns is the industry standard for measuring investment performance because geometric returns paint a more useful picture of a stock’s impact on wealth creation (or erosion) over a stated period of time.
Unfortunately, no investor is spared from these simple mathematical facts. 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.
Past performance does not guarantee future results.
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.