Season Investments


The Economics of Loss

Posted on January 17, 2017

“Some religiously stick to buy-and-hold.  That's ok over 30 years if you can do it.  It's not ok if you get run over by a 50% market correction if you are a pre-retiree or retired.” – Steve Blumenthal

2017-01-17_piggycalc.jpgIf you know us or have been reading this blog for any amount of time you already know how seriously we take risk management. Our obsession with insulating our client portfolios from the risk of a significant drawdown permeates every aspect of our investment approach. In our last two Insights (An Alternative To Buy-And-Hold, A Subtle Difference) we unpacked why a buy-and-hold investment strategy may not be appropriate for every investor and why trend following should be considered one acceptable way to systematically manage risk. In this week's post we will continue along that same line of thinking and unpack why a strategy without a risk management protocal, such as buy-and-hold, makes less and less sense the closer one gets to retirement because of something known as sequence-of-return risk.

There are several reasons we are so obsessed with managing risk with downside protection. First off, there are what we would consider “soft” reasons, not the least of which is the need to account for human nature. The role of human emotion in investing is a topic we explore thoroughly in The Cost Of Being Human.

“There is a true cost of being human, and rather than trying to stifle natural emotional responses we should account for them on the front end and plan accordingly. This is why we put such a high degree of emphasis on proactive risk management.”

In addition, there is also a wealth of mathematical and statistical theory supporting our emphasis on limiting drawdown exposure. In the same way that positive growth can compound over time to produce mind-blowing results, large negative returns can also be surprisingly destructive to a financial plan. Consider the fact that a 20% drawdown requires a subsequent 25% return to fully recover, while a 33% drawdown takes 50% to recover and a 50% drawdown takes 100% to recover. These types of drawdowns are not merely theoretical; we have heard plenty of real world examples of financial futures being crushed under the weight of losses of this magnitude (and even larger in some cases).

It’s important to remember that the underlying capital we have to invest is the required fuel for growth. It’s the raw material. Thus, growing capital over time is about striking an appropriate balance between preserving capital in turbulent times and capturing growth in good times. The reality is that if you incur a large loss you don’t enter the next performance period with the same amount of starting capital…you have to make up the lost ground by starting with less raw material. On the homepage of our website we have a short video explaining the mathematical realities of what we call “The Economics of Loss”. This video further unpacks what we consider the “hard” reasoning behind our sensitivity to drawdowns.

This obviously isn’t a new topic for us, but what we’d like to call attention to in this post is that reducing volatility in investment returns becomes exponentially more important the closer you are to retirement. This is true for a number of reasons. First of all the sheer number of dollars at risk is greatest near the end of an individual’s accumulation phase. This increases the risk of “sticker shock” from losses and amplifies the human emotion part of the equation. Additionally, the timeline is shorter for potentially recovering a large drawdown, and the prospect of taking cash withdrawals out of the portfolio in retirement only acts as a further headwind.

This dynamic was captured in a recent article in Financial Advisor magazine which stated,

Known as sequence-of-return risk, it can decimate even the best-laid retirement plans. The havoc caused is something from which the retiree will most likely never recover, diminishing the quality of life of which they’ve dreamed.

 Too many investors fail to realize that it’s not only about the loss of monetary resources, but also the loss of time in which to make them back. For young investors just starting out, its impact is negligible. Not so for their older counterparts, one reason sequence-of-return risk rises with time, and is at its highest just before retirement.

Sometimes it can be difficult to clearly communicate how important this concept is. After all, quantifying “risk” is somewhat elusive; it’s impossible to report the risk that was taken with the same clarity that we can report rates of return. While unfortunate, this reality does nothing to diminish the importance of us and our clients constantly seeking to identify, understand and manage risk well. To continue this effort next week we will present a brand new illustration of The Economics of Loss by measuring the sustainability of an individual’s retirement plan under different risk/return assumptions. This illustration will be a new tool in our toolbox of client education, and we are hopeful it will further illuminate an important concept. 

david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

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Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.