We continually research academic studies on portfolio construction to consider their merit. The investment landscape is always evolving so we feel we must keep abreast of such studies and if appropriate assist our clients in expanding their investment education, even though we may not necessarily agree with the conclusions. Below is just one example of this.
Managing volatility in portfolios is an enormous topic. This article deals with what has been called “the power of less downside”.
It is easy to become obsessed with chasing the upside and in every cycle, investors want to try to pick the bottom of the market to buy and the top of the market to sell. When it comes to selling we want to feel smart and leave nothing on the table. However, as much as we may regret selling too early, we feel the pain of loss so much more.
Ultimately, however, what we should really focus on is not the market but achieving what we need to achieve; to be targeting our own goals which are not necessarily market related.
So, what does this have to do with volatility?
Investing is a lifelong activity and being comfortable with the journey can reduce what some people find stressful. Being comfortable with the journey can be an important factor in managing happiness.
Markets, however, foil us frequently and sometimes it is not about making money, it is about minimising loss. This is about keeping your eye on the long game – if we lose less in down markets we have more to participate in the inevitable upswing and experience a more powerful compounding effect.
When looking at managed funds which invest in equities we can assess how the strategy performs by looking at their upside capture and downside capture ratio over a long period of time. This ratio, as the name suggests, shows how much a strategy gained relative to an index during an up market and the converse in a down market.
State Street recently released a study looking into the long-term impact of participating in a portfolio that seeks to captures 80% of up markets and 60% of down markets. The longest data set used was the Dow Jones index from 1900-2018. The average positive month returned 3.74% and the average negative month returned – 3.84%.
Over this entire period, an 80:60 strategy delivered outperformance of 3.6% per annum with lower volatility.
As astounding as this is, the strategy does not always outperform – there were two decades in which the strategy underperformed. The underperformance was marginal but would perhaps have been enough for some investors to chase returns elsewhere.
Some of the key outcomes included:
Limiting the participation in down markets is more important than participating in all the upside.
The strategy may be particularly helpful for retirees who are drawing off their portfolio to fund retirement. A further lookback on the impact of investing in the S&P500 was also undertaken. The following graph, for illustrative purposes only, assumes a $1m portfolio with a $9,000 per month drawdown. Drawdown can be daunting for retirees when they rely entirely on their portfolios and uncertainty of future returns disconcerting.
Interestingly, the current decade since 2010 has experienced the second lowest level of volatility since the 1950’s. During this time the strategy has broadly matching market returns. However, if volatility is expected, such a strategy may be worth exploring if it suits an investors risk profile and objectives.
The full study can be found here.
Cover image- Cleinman Performance Partners
Disclosure Statement: This communication has been approved and issued by Sovereign Wealth Partners Pty Ltd ABN 18 607 071 367 Corporate Authorised Representative (No. 001233909) of Sovereign Capital Pty Ltd ABN 44 164 127 833, AFSL 456235.
General Advice Warning: Any advice included in this article and associated links is general in nature and does not take into account your objectives, financial situation or needs. If a product we recommend has a Product Disclosure Statement (PDS), you should read it before making a decision. Past performance is not a reliable indicator of future performance. We do not endorse any information from research providers that we provide to you, unless we specifically say so.