Absolute return strategies aim to generate positive returns irrespective of market direction. A truer more apt definition is that absolute return, or active investment management, seeks at all times to minimize losses. We mentioned this as a core attribute of an absolute return strategy in “Why an Absolute Return Strategy”, but this simple concept is worth further description.
On the surface, advising one to limit losses would seem to re-state the obvious, but a precious few investors truly understand why this is so important. This piece provides examples that drive this point home. By doing so, we demonstrate the value added to an investment portfolio that is partially allocated or possibly fully committed to an absolute return strategy.
First, consider the percentage gains that are required to fully recover from losses. If one takes a modest loss of 10% in their portfolio then the math demands a gain of 11.1% to break even. If a stock priced at $100 drops 10% to $90, an identical 10% gain from $90 only affords a recovery to $99 ($90 x 10% = $9). The subsequent percentage gain must be larger than the original percentage loss to fully recover what one has lost ($10/$90 = 11.1%). The chart below demonstrates why smaller losses may be manageable but large losses are devastating.
In scenario A, a return of 33.33% is required to fully recover from a 25.00% draw-down. As losses grow, however, the return required to offset the losses grow exponentially. Scenario B, for instance requires a return of 100% to offset a 50% loss, while an investor who lost 75%, as in scenario C, requires a whopping 300% to break even. The takeaway from the graph above is that the subsequent percentage gain required to recover a loss is much lower when losses are diminished. Additionally, the recovery percentage required to break even rises at an increasing rate as losses escalate.
To further emphasize why limiting losses is essential to building wealth, we present a real-world example. Since March 2000, the S&P 500 has suffered two serious setbacks – the first one beginning in the year 2000 and extending through 2002 was a decline of over 47% and the second during the more recent 2008 financial crisis was a drop of over 55%. The robust equity market recovery since 2009 produced a full re-capture of the pri
or two setbacks resulting in a 1.80% annualized total return for those that held stocks through the 15-year period.
The chart below considers an alternative scenario, however. Suppose an investor had astounding foresight and reduced their equity positions in half during the two aforementioned downturns. In this case, the fortunate investor (investor B in the chart below) would have amassed a gain of 148%, approximately 4.5 times greater than an investor (investor A) who held a steadfast 100% position in the S&P 500.
There are two perspectives one can use in investing. Either invest capital in a way that will maximize gains or invest it in a manner that will prevent large losses. Investing to maximize gains generally implies that the risk of loss is subordinated to the opportunity to make money. In this way, the gains that can be garnered is given psychological precedent in this strategy. Alternatively, focusing on the exposure to loss radically changes how one evaluates opportunities.
Limiting losses, which may at times reduce potential gains, produces a much more powerful positive compounding effect over the long run and helps make wealth objectives more easily achievable. Lance Roberts, Realinvestementadvice.com, sums this up nicely as follows:
“It is ALWAYS okay to miss out on an opportunity, as opportunities come along as often as a taxi-cab in New York City. However, it is IMPOSSIBLE to make up losses as you can never regain the time lost getting back to even”.
CTA’s offer unique strategies, many of which were discussed in “Absolute Return Strategies”, that can play a role in helping an investor build an absolute return portfolio.
**This discussion on losses is supported by the research of Ed Easterling at Crestmont Research. For further reading on the topic we highly recommend reading Half & Half: Why Rowing Works by Ed Easterling.