Risk and Return - Weathering Inevitable Drawdowns

With changes in weather, we change our clothes. The more wide-ranging and unpredictable the patterns, the bigger our closets. So, it goes with our investments. Markets can shift from balmy rally to stormy correction in an afternoon. And our natural response to an abruptly changing environment, depending on the direction, is to duck and run for cover or to swap the coat and umbrella for shorts and sunglasses. But what if we build our investments with an all-weather attitude in mind? That basic mindset defines our risk-conscious approach.

The first element of that approach is to determine, to the best of our ability, our individual tolerance for market risk. In gauging that tolerance, we really mean to determine our stomach for losses along two dimensions: depth and time. How much can we stand to lose over what time frame?

Seeking to answer that question, a review of market history is pertinent. For this discussion, we generally prefer to combine a view of long-term returns with a view of the range of “drawdowns” experienced along the way. A drawdown is the maximum market decline from a prior peak prior to a recovery, back to that same peak. A drawdown also can be expressed as the length of time after an initial loss for an index to recover to a prior peak.

We can use data from the U.S. stock market to provide context for looking at return and risk over time. In the top part of Figure 1, we show for the S&P 500 Index the long-term total return since the beginning of 1926. At the bottom of the chart we show the drawdowns over that same time frame. The long-term return portion of the chart is there to express the historical potential gains for having owned U.S. stocks. The drawdown chart is there to demonstrate that a long-term horizon may have been required to have achieved those long-term gains.

We show the two charts together to reinforce the idea that, while very long-term returns certainly can be described as robust, those returns came with substantial volatility. And investors might have experienced long periods of time underwater on their stock investments before seeing any gains at all: volatility is a two-way street. While we know folks often wish to focus on the potential gains to be had from investing, we cannot forget the risk side of that balance, because myriad studies have shown that the mental regret humans derive from loss can be more powerful than the mental benefit derived from an equivalent gain. Better then to ask ourselves what level of losses in the interim—what level of drawdown—might we be able to tolerate so that we can remain invested in order to achieve those more favorable long-term expected returns.

A Portfolio That’s Right for You

As we discussed in our story about the differences between stocks and bonds [link], the various models made available to clients on the Altafid platform differ primarily by their splits between equity and fixed income, which in turn express a relative level of overall expected risk and return. And with our risk tolerance questionnaire, which every client completes at the start of the account-opening process, we seek to answer what level of risk (volatility, losses and/or drawdown) might leave an investor too weary and wary to remain invested. The challenge is to offer a fair representation of potential return, while being careful not to needlessly scare investors from equity.

As we demonstrated in our stocks and bonds article [link], stocks generally have provided higher longer-term returns than bonds. Stocks also generally are more volatile than fixed-income markets. And that has meant that equity-related losses generally have proved larger, longer-lived and more frequent than they have for broader fixed-income markets. In working with our clients, we therefore like to revisit the performance of various mixes of equity and fixed income over time, first to show how return and risk are related, and second to assess client comfort with that tradeoff.

The purpose of the reviews most certainly is not to scare folks from investing. Rather, we hope to provide support for clients to be invested over the long run. Indeed, the goal of these conversations we have with clients is to resolve a suitable approach that acknowledges each client’s unique mix of life goals, interim challenges, and range of aversions to market uncertainty. And in doing so, we believe we help clients stay on top.

The S&P 500 Index measures the performance of 500 largest US companies and captures approximately 80% of available market capitalization

This material is for informational purposes and is intended to be used for educational and illustrative purposes only. It is not designed to cover every aspect of the relevant markets and is not intended to be used as a general guide to investing or as a source of any specific investment recommendation. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. This material does not constitute investment advice, nor is it a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. In preparing this material we have relied upon data supplied to us by third parties. The information has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made by Altafid, PBC or its affiliates, as to its accuracy, completeness or correctness. Altafid, PBC or its affiliates do not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regard to the results obtained from its use. Altafid, PBC or its affiliates have no obligations to update any such information.