You have to manage your risk

In this series, we’ve asked Covestor managers: “What is the single most important lesson you’ve learned while striving to become a successful investor?”

To anyone under 40, I warn you now that you’ll be tempted to discount the following. My experience tells me that you shouldn’t.

The prevailing marketing by investment companies is that taking on risk is acceptable when you are young and have time to recover. In fact, many young investors almost feel it’s their obligation to take on risk. “Steady,” “predictable,” and “dividends” are all terms that refer to their parents’ portfolios.

Yet the single most important lesson I’ve learned in managing other peoples’ money for over 25 years is that unmanaged risk is rarely rewarded. Gaining more return simply by turning up your risk dial is in reality an oxymoron. Sure, you can make more money with more risk. But smart investors understand how minimizing risk of loss increases their probability of success. This doesn’t necessarily mean you need to avoid risky investments. It only means understanding and then managing the risk to hedge against investment losses.

Consider the following.

The logic behind the statement “risk is OK when you’re young, because you have time to make it back” is pretty obvious. If you lose $10,000 at age 30,you have plenty of time between now and retirement to make it up, whereas a 64 year old who loses $10,000 from his retirement fund, a year before retirement, is just going to have to settle for a retirement account that’s $10,000 smaller.

Let’s look again at our 30 year old with a $10,000 portfolio loss at age 30. Assuming he is able to generate an average annual return of 10% (which is approximately the average annual return of the S&P 500 since 1971), and he retires at age 65, his lost $10,000 could have grown to $281,024 if he had maintained his capital and invested it in the S&P 500. For our near retiree, however, a $10,000 loss is truly a $10,000 loss. Time compounds returns. It also compounds the opportunity cost of losses.

Market declines are common, as shown in Table 1 below.  This time always feels different, but in reality the market is remarkably consistent. The reasons are different, but the resultant ups and downs of the market are the same.

Table 1. Market Declines

market decline and time

Remember, averages are just that. To get an average takes a series of higher and lower observations. Note that >40% losses only happen once every twenty five years. We’ve had two in the last 12 years. Consequently, the stock market has been mostly flat since 2000. By comparison, we avoided a 40% drop in the 1980’s and 1990’s, when the S&P 500’s average annual return was nearly 20%.

I tell my clients that you have to expect declines if you’re invested in the market. But I also tell them it is very much our goal to limit the major declines to under 20%. The math is simple. If we lose 20%, I only need a 25% return to get back to even. But a 50% loss requires a 100% return to be whole again. It can take a long time to get a 100% cumulative return in the stock market.

More importantly, if I need only a 25% return to stay even with the market, as opposed to requiring a 100% return, I am not pressured to take on even more risk to play catch-up.

I frequently speak to other investment advisers about their practices and investment ideas. I’m always open to expanding our business or our investment strategies. Recently, I had two enlightening conversations.

One gentleman gave an eloquent explanation of his overall strategy and provided an investment position he thought I should take. When I didn’t agree with his thesis, he argued why he was right.

More recently, I had a similar conversation with a different adviser. When I asked him what he would do if the market didn’t cooperate with his strategy, he immediately began talking about his hedging strategies and what steps he’d take if he was wrong.

I haven’t spoken since with the former adviser, and I am planning a meeting with the second.

That is my final piece of advice. Both individual investors and advisers can typically speak quite eloquently about their investment strategies. But the best money managers are those who can speak equally well about how they hedge and manage their risk.

If you’re looking for an advisor, it’s not so important that you understand that hedging strategy. It’s important that you find an advisor who has one.

Disclosures: Certain information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. The manager believes that such statements, information and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.

Any investments discussed in this presentation are for illustrative purposes only and there is no assurance that the adviser will make any investments with the same or similar characteristics as any investments presented. The investments are presented for discussion purposes only and are not a reliable indicator of the performance or investment profile of any composite or client account. Further, the reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions made by model managers in the future will be profitable.