You Can’t Win if You’re Afraid to Lose

To ex­pe­ri­ence higher po­ten­tial gains, clients need to be will­ing to tol­er­ate losses at least oc­ca­sion­ally. Strik­ing the right bal­ance be­tween risk and re­ward is the tricky part.

Financial Planning - - Contents - BY CRAIG L. ISRAELSEN

To ex­pe­ri­ence higher po­ten­tial gains, clients need to be will­ing to tol­er­ate losses at least oc­ca­sion­ally. Strik­ing the right bal­ance be­tween risk and re­ward is the tricky part.

No pain, no gain.

That’s an im­por­tant les­son clients have to un­der­stand when build­ing their port­fo­lios. To max­i­mize their po­ten­tial re­turns, they need to be will­ing to stom­ach some risk and ex­pe­ri­ence losses, at least part of the time.

But just how fre­quent and how deep can those losses be, be­fore the risks no longer war­rant the re­wards those in­vest­ments could de­liver? An­a­lyz­ing mu­tual funds over the past 20 years, shows there may be a sweet spot for your clients.

In “The Mu­tual Fund Uni­verse” chart be­low, I cat­e­go­rized ev­ery mu­tual fund (in­clud­ing ev­ery type of eq­uity fund and ev­ery type of fixed-in­come fund) that sur­vived over the past 20 years by how of­ten it ex­pe­ri­enced a neg­a­tive re­turn in a cal­en­dar year. There were 2,482 funds over­all, and this study in­cluded only the mu­tual fund with the old­est share class to avoid dou­ble- and triple-count­ing funds that have mul­ti­ple share classes.

Among that group, 273 funds (11% of the to­tal) never had a cal­en­dar-year loss over the past 20 years. As you would prob­a­bly ex­pect, this group was dom­i­nated by money-mar­ket mu­tual

funds and short-term bond funds. Their av­er­age 20-year stan­dard de­vi­a­tion of an­nual re­turns was just 1.97% — a very low level of volatil­ity, in­deed.

How­ever, low risk tends to de­liver lower re­wards. Af­ter all, the av­er­age 20-year an­nu­al­ized re­turn for a lump-sum in­vest­ment on Jan. 1, 1998, was a mea­ger 1.86% per year. This means a $10,000 in­vest­ment made in 1998 would to­tal only $14,563, on av­er­age, af­ter 20 years.

Do not over­re­act to small cal­en­dar-year losses. It is the large, fre­quent losses that we are re­ally try­ing to avoid.

The mes­sage is quite clear: If your client wants to avoid neg­a­tive cal­en­dar-year re­turns, he or she needs to also be OK with a bare min­i­mum level of re­turns.

The next group of mu­tual funds ex­pe­ri­enced a neg­a­tive cal­en­dar year only once in the 20 years — a 5% fre­quency of loss. There were 100 funds in this group, nearly all of which were bond funds. In­ter­est­ingly, there were a cou­ple of funds with eq­uity ex­po­sure (Van­guard Life Strat­egy In­come and T. Rowe Price Cap­i­tal Ap­pre­ci­a­tion). The av­er­age 20-year stan­dard de­vi­a­tion for the 100 funds was 3.55% and the av­er­age size of the one neg­a­tive cal­en­dar-year re­turn was -3.43%. The av­er­age 20-year an­nu­al­ized lump-sum re­turn was 3.9%.

How­ever, as might be ex­pected be­cause of their eq­uity ex­po­sure, the Van­guard Life Strat­egy In­come fund had a 20-year av­er­age an­nu­al­ized re­turn of 5.17%, while the T. Rowe Price Cap­i­tal Ap­pre­ci­a­tion fund came in at 9.99%. Clearly, those two funds were the out­liers in a group of pri­mar­ily fixed-in­come funds.

The next group of mu­tual funds (153 of them) had a cal­en­dar-year loss 10% of the time (that is, two years out of the 20). As ex­pected, the stan­dard de­vi­a­tion for this group was higher at 5.38%, as was the av­er­age cal­en­dar-year loss of -4.88%. The re­ward for ex­po­sure to a 10% fre­quency of losses was an av­er­age 20-year av­er­age an­nu­al­ized re­turn of 4.86%.

Per­for­mance Re­ward

As you fur­ther ex­am­ine the data in the ta­ble, it be­comes clear that a higher fre­quency of losses is pos­i­tively cor­re­lated with a higher stan­dard de­vi­a­tion of re­turns and higher av­er­age size of an­nual losses (when they oc­cur).

For ex­am­ple, among the 88 funds that had cal­en­dar-year losses 40% of the time, the av­er­age stan­dard de­vi­a­tion of re­turns was 28.06%, and the av­er­age cal­en­dar-year loss was -15.87% — both of which were con­sid­er­ably higher than funds that had losses 20% of the time.

It’s also im­por­tant to no­tice that there was not a ma­te­rial per­for­mance re­ward pro­vided by the funds that had losses 40% of the time ver­sus the funds with losses 20% of the time. The 88 funds with losses 40% of the time had an av­er­age 20-year an­nu­al­ized re­turn of just 6.82%, which was only 17 ba­sis points higher than the 6.65% av­er­age an­nu­al­ized re­turn for the 505 funds that had cal­en­dar-year losses 20% of the time.

Clearly, there is a point at which the fre­quency of losses and the size of the an­nual losses be­gin to di­min­ish the per­for­mance po­ten­tial of a mu­tual fund or ETF.

As high­lighted in the ta­ble, this tran­si­tion point ap­pears to co­in­cide with a 25% loss fre­quency. In other words, the 452 mu­tual funds that ex­pe­ri­enced losses 25% of the time had the high­est av­er­age an­nu­al­ized re­turn. When the fre­quency of an­nual losses ex­ceeded 25%, there was a con­sis­tent de­crease in 20-year per­for­mance. What does all this sug­gest?

First ob­ser­va­tion: To max­i­mize po­ten­tial re­turns, your clients have to be will­ing to ex­pe­ri­ence losses some of the time — but not more of­ten than 25% of the time on an an­nual ba­sis. We are not talk­ing about daily or monthly re­turns here — that sort of be­hav­ior be­gins to look like day trad­ing.

Sec­ond ob­ser­va­tion: Loss fre­quency needs to be mea­sured over a suf­fi­ciently long pe­riod of time — in this case, 20 years — to rea­son­ably cap­ture the gen­eral be­hav­ior of the fund.

Third ob­ser­va­tion: Funds in the loss-fre­quency range of 25% to 40% have cal­en­dar-year losses that are sur­pris­ingly sim­i­lar in size, on av­er­age. Only when the loss fre­quency es­ca­lates to 45% or 50% does the av­er­age size of the neg­a­tive cal­en­dar-year re­turn be­gin to spike up­ward.

This sug­gests that some of the an­nual losses among funds that have an­nual losses 25% to 40% of the time are rel­a­tively small — but losses nev­er­the­less. The take­away from this is to not over­re­act to small cal­en­dar-year losses. It’s the large, fre­quent losses that we are re­ally try­ing to avoid when build­ing port­fo­lios for clients.

Ap­pro­pri­ate Level of Re­turn

This is a vi­tal point. The pri­mary job of a well-di­ver­si­fied port­fo­lio is to de­liver the ap­pro­pri­ate level of re­turn needed by the in­vestor, but to do so in a way that min­i­mizes both the fre­quency and mag­ni­tude of an­nual losses. Why? Be­cause clients ob­serve and of­ten re­act badly to in­vest­ment losses.

A typ­i­cal mea­sure­ment of risk is stan­dard de­vi­a­tion of re­turn — but that is not an in­tu­itive statis­tic for most peo­ple. Very few clients are in­clined to cal­cu­late the stan­dard de­vi­a­tion of their port­fo­lio, but they can prob­a­bly re­cite from mem­ory the last time their

port­fo­lio had a neg­a­tive an­nual re­turn and also re­mem­ber the size of the loss.

The point is that the com­mon mea­sure of risk — stan­dard de­vi­a­tion — is prob­a­bly not how ac­tual in­vestors per­ceive and in­ter­nal­ize risk in their port­fo­lios.

Risk-re­turn Spec­trum

Shown be­low in “From Less to More Di­ver­si­fied” are three in­vest­ment ap­proaches. The first is a 100% in­vest­ment in the S&P 500 (via VFINX). This is an all-eq­uity ap­proach.

Next is Van­guard STAR, a fund-of-funds that com­prises 11 other Van­guard funds to achieve a 60% eq­uity/40% fixed-in­come as­set al­lo­ca­tion.

Fi­nally, there is a broadly di­ver­si­fied ap­proach that in­cor­po­rates 12 Van­guard ETFS and achieves a 65% al­lo­ca­tion in eq­ui­ties and di­ver­si­fies the bal­ance in var­i­ous fixed-in­come funds. This ap­proach, which I de­vel­oped, is known as the 7Twelve Port­fo­lio.

Over the past 20 years, among these three ap­proaches, the most di­ver­si­fied port­fo­lio had the best per­for­mance. In­ter­est­ingly, the 7Twelve model and Van­guard 500 In­dex both had loss fre­quen­cies of 20% (mean­ing four cal­en­dar-year neg­a­tive re­turns over the past 20 years).

How­ever, the key dif­fer­en­tia­tor was that the 7Twelve model’s av­er­age an­nual re­turn was -8.6%, whereas the Van­guard 500 In­dex had an av­er­age cal­en­dar-year loss of -20.1%, while Van­guard STAR’S av­er­age re­turn was -11.7%.

Build­ing a port­fo­lio that does not ex­pe­ri­ence an­nual losses more than 25% of the time is im­por­tant, but it’s also cru­cial to keep the losses small when they do oc­cur.

That is one of the key rea­sons to build a broadly di­ver­si­fied port­fo­lio. It won’t make losses go away, but it will prob­a­bly re­duce the size of the losses when they do oc­cur.

Source: Steele Mu­tual Fund Ex­pert; cal­cu­la­tions by author

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