An Ounce Of Prevention Is Worth a Pound Of Cure
One of Benjamin Franklin’s well-known aphorisms is, “An ounce of prevention is worth a pound of cure.” Could this apply to the world of investing as well? Yes, as it turns out.
I’ve written before on the topic of volatility drag (see https://www.cognizantwealth.com/2012/05/15/volatility-is-a-drag/) which causes an investment whose return is constantly fluctuating between positive and negative to lose value over time. The source is the asymmetry of positive and negative returns, which is well-known mathematically. Simply put, it takes a greater percentage return to recover from a smaller percentage loss. As the percentages increase, the difference becomes more pronounced. This can easily be observed in the following table. Assume a starting amount of $100. How much return would be needed to get back to $100 after various percentage losses?
Loss Ending Amount Needed Gain Final Amount
10% $90 11.11% $99.99
20% $80 25% $100
30% $70 42.86% $100
40% $60 66.67% $100
50% $50 100% $100
As the table illustrates, to break even from a 10% loss, it takes an 11.1% return. With a 20% loss, a subsequent 25% gain is required. In effect, in terms of percentage returns (which is how investment performance is commonly measured), avoiding a loss is the economic equivalent of capturing a larger gain. Put another way, it is 5% (or 500 basis points) more valuable to avoid a 20% loss than it is to achieve a 20% gain. The takeaway is that a good investment strategy should have a greater focus on loss prevention than on growth.
This is not to say that growth should be ignored. You can’t put all your savings into a bank CD paying 1% below the rate of inflation and expect those savings to support you for a thirty-year retirement lifespan. You still need to invest in growth-oriented assets such as stocks. Of course, the higher the growth target, the higher the risk (and consequent volatility). But from the data above it’s clear that some growth is worth sacrificing if you can get some good protection on the downside.
The mutual fund industry offers numerous products designed to reduce volatility in several different ways. There are funds that actively shift from stocks to other asset classes based on changes in company or economic factors (aka fundamental analysis) and those that do the same thing by following price and market movements (technical analysis). Both strategies, however, are predicated on the fund manager’s ability to successfully predict the future. That’s not an approach I’d recommend staking your portfolio on.
More promising has been the evolution of funds and ETFs that utilize options on stocks (puts and calls) or swaps to try to hedge against downside risk, as well as those that use stock screening or other strategies to directly reduce volatility in specific equity asset classes such as the S&P 500. But there is no free lunch. There’s always a cost to adding protection, and it will be reflected in the fund’s expenses, in its performance, or in both. It’s up to the investor to determine whether or not the additional cost is worth the protection.
In summary, making investment choices based on protection may be more valuable to your portfolio that simply focusing on growth. But only if they’re worth the additional cost.