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Losing Less Makes MORE


This paper is an accumulation of reports/studies/conferences I have attended over the last few years that have become the cornerstone of my Investment Management Philosophy. In the most basic sense, protecting portfolios from large market drops is equally, or more important than participating in large market gains. As said by Benjamin Graham, “The Essence of Investment Management is the Management of Risks, not the Management of Returns. Well Managed Portfolios Start with this precept.”

First, I want to present the concept of Upside/Downside Capture. Upside capture is the percentage of a positive growing market you capture. For example, an upside capture of 110% means that for every 1% the market increases, the portfolio goes up 1.1%. Conversely, a downside capture is the percentage of a negative dropping market you capture. A downside capture of 75% means for every -1% the market returns, the portfolio only drops -0.75%. This provides an easy method to discuss how a portfolio performs in both good and bad markets.

Consider the example of the past 15 years, admittedly not the best stretch for equity markets. During this period, there were two significant bear markets: 2000 and 2008. During the first, the S&P 500 declined roughly 45%. In the most recent bear market in 2008, the drawdown was more than 50%. In hindsight, a strategy designed to capture just 50% of the market movement would have not only reduced volatility and the magnitude of the two draw downs, but would have also resulted in a slightly larger cumulative return (see Figure 6). In other words, a hypothetical S&P 500 portfolio of $10,000 would have grown in that period to $18,160. But a strategy that captured 50% of the upside and the downside would have grown to $18,786, thus illustrating the importance of mitigating downside losses, even when it means missing out on some of the gains in market rallies.

Source: BlackRock

Looking more specifically at the last market cycle, from the market peak in October 2007 through the close of 2015, it is instructive to ask the following question: What capture ratio would have generated the highest total return? Again, this is a theoretical question as the actual capture ratios would not have been known in advance. Still, the exercise is instructive if only to emphasize the point that a portfolio designed to mitigate downside risk, even at the cost of limiting upside, may have done better than a portfolio with exposures similar to the broader equity market.

The next question is how low do you go? Obviously, a capture ratio of 0 would not be optimal, unless markets were in a long-term secular bear market. The fact remains that over the long-term markets do rise, suggesting that investors want to participate in those gains. The key is to hone in on a reasonable range that provides downside mitigation while still taking advantage of those long periods when markets are advancing. 

Acknowledging capture ratios are a historical statistic, it is reasonable to prescribe an optimal range. During the last cycle, in which the S&P 500 fell 51% and then rebounded 221% during the financial crisis and subsequent recovery, a capture ratio for large-cap stocks—both upside and downside—of between 50% and 75% would have been optimal.

It is important to note that downside mitigation is particularly important when an investor is withdrawing money from his or her account, for example during retirement. Figure 9 shows the impact of a 4% annual withdrawal from a hypothetical large-cap stock portfolio during the financial crisis and subsequent rebound. It illustrates how the optimal downside capture goes from 75% to 57% when in withdrawal mode, according to the research.

Source: BlackRock

If a retired investor had a 100% downside capture rate during the 2008 market crash and lost 51% or their retirement funds, the future withdrawal rate (rate for which they are withdrawing funds) basically doubled! If they started with $1,000,000 in 2007 and were withdrawing 4%, or $40,000 and their account dropped to $490,000 (51% loss), the $40,000 now represents an 8.2% withdrawal rate.  Can a retired investor expect an 8.2% average return the rest of their lives? Since most of our clients at MPBWM are nearing or in retirement if a retiree was fully exposed to a 51% market drop, there is little chance they could recover economically and maintain the pre-crash income, hence the name of this paper, Dollar Cost Ravaging.

It is difficult for most investors to understand that they are better off if they Over perform during market crashes (losing less than the markets), even if they Underperform during positive market recoveries! Of course, every investor would choose to over perform both positive and negative markets, but I’ve never seen any manager consistently be able to do so.


“The problem in defense is how far you can go without destroying from within what you are trying to defend from without.”

— Dwight D. Eisenhower

During the past year, the focus for many has shifted from return on capital to return of capital. Volatility has once again intruded on what was a very pleasant, and prolonged, upward march in equity markets. Given the lingering uncertainty over growth, the growing impotency of monetary policy and deteriorating credit market conditions we believe volatility is likely to remain elevated. This suggests that the renewed focus on managing volatility is reasonable. The math of compounding suggests that in many instances, specifically in a market characterized by above-average volatility and large drawdowns, downside mitigation is critical, and not just for managing volatility. Strategies that limit downside capture may potentially produce higher cumulative returns over the long-term.

The challenge is finding and allocating to those strategies before the fact. Not all downside mitigation will work equally well in every environment. For investors with a strong view on the source of the volatility, tactical allocations, such as up-weighting exposure to quality companies, may make sense. But a more strategic approach is to allocate to several strategies emphasizing lower capture ratios as part of a long-term allocation. Potential examples include global flexible mandates, minimum volatility and funds focused on dividends, hedged equity, long/short, and momentum funds, all of which can help mitigate downside capture.

None of these strategies, either in isolation or in tandem, will completely insulate a portfolio, but they can help mitigate the damage inflicted by today’s turbulence. Less damage translates into a somewhat shallower hole to climb out of when markets finally do turn.