Why Your Downside is MUCH More Important Than Your Upside
By: Justin Larson, CFA.
People love talking about their winners. The obscure biotech stock that quadrupled, the SPAC that went up 300%, the cryptoasset they bought that subsequently went vertical in a month, the tip they received on Apple early on before it was a household name. I like talking about the small clothing retailer I bought that went up 700% much more than I like talking about the AI software company I bought that’s down 79% (ouch). Below we’ll look at why your investment performance on the downside is exponentially more important than the performance on the upside.
With help from two BlackRock charts, we hope understanding the math behind upside and downside can make you a better investor and help focus on the risk-return tradeoff, rather than solely on return. This mathematical principle is key to construction of our portfolios.
The first chart below shows how $100,000 invested before the Great Financial Crisis grew through the end of 2021. On the left, you invest in the S&P 500 and just let it ride. You end with $408,120. On the right, you invest in a less-risky portfolio that earns 75% of the S&P 500 return on the upside, and 75% of the S&P 500 return on the downside. In this scenario, you end up with $410,998. We can call the end results essentially the same, but why does getting only three quarters of the upside and three quarters of the downside lead to similar results as getting the full upside and full downside?
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return do not reflect the deduction of fees and charges inherent to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The answer lies in the chart below. A 30% loss followed by a 30% gain does not get you back to even. You’d still be down 9% overall. If you lose 30%, you actually need a 43% gain to break even. This math works harder against you the deeper the losses are. To recover a 70% loss, you need a 233% gain! This is why limiting your downside during periods like right now is incredibly important. The less downside you can realize, the less of a recovery you need to break even or make money. And perhaps most importantly, the less risk you need to take on.
This doesn’t mean you should try to time your entry and exit points in the market to limit your downside, but it does mean you should think carefully about how you select your investments. Selecting volatile investments that swing more than the overall market can be fun on the way up, but during periods of loss, they can set your portfolio back and make it more difficult to recover losses.
Now imagine if you can find investments or build a portfolio that can limit the downside, but also capture nearly all, or all, of the upside. Say you invest $100,000 into a fund that can do what we just referred to while your friend invests $100,000 in an index fund. This time, instead of getting 75% of the upside and 75% of the downside, your fund gets 75% of the downside and 80% of the upside. Your friend’s fund gets 100% on both sides. You then get the below returns for three years.
Even though your fund never matches the index fund returns on the upside, just limiting the downside and doing “decent” on the upside may lead you to a higher ending value, AND you took less risk. The difference is small over three years but think if you can repeat this over a decade. Or two. Through a bear market. Or a few.
This principle underlies how we manage portfolios at Exeter. We believe we can take less risk for client portfolios versus the overall market, but still create more value over time. If you have any questions on what was covered herein, please don’t hesitate to contact us.