On a recent trip to Park City, Utah, my family and I ventured over to the most intimidating ski terrain we have ever visited – Snowbird Resort. The mountain is littered with steep grades and cliffs, exposed rock, narrow cat tracks and some of the highest ski lifts I have ever been on.
If you take any of the lifts to the peak of the hill, you can see very little in any direction, except of course the edge of the narrow ridge you are standing on and other mountains off in the distance. There is, quite literally, nowhere to go but down. And fast!
As U.S. markets linger near all-time highs, many investors are starting to feel like they are standing at the peak of the mountain at Snowbird.
For some, this produces a desire to retreat while searching incessantly for the safest way out. They sense an imminent danger, freeze in place, and seek to eliminate that feeling as quickly as possible.
The safest way down from the top of a ski mountain is to hop back on the aerial tram and ride it down to the bottom. Someone who chooses this path is technically safe, but missed the whole point of being there in the first place.
For others, this experience provides an adrenaline rush. They have an opportunity to stretch themselves and take a more interesting path on the next run.
Each time they make it down the slopes safely, they begin to forget about all the rocks and cliffs they passed on the way up. Their past success breeds confidence and reduces the perceived threat.
In a perfect world, saving and investing would both lead to a slightly new high each day. Unfortunately, markets do not work that way.
Like the skier that falls numb to the risks over the next ridge, investors who stretch too far expose themselves to potentially devastating results. Conversely, investors who seek shelter miss out on future gains.
One of the fundamental cornerstones of our investment philosophy is having a strong understanding and appreciation for the level of risk taken in a portfolio. We understand the consequences of stretching too far in any direction, and seek only to take as much risk as is necessary to meet an investor’s objectives.
The world of Alpine skiing has developed a similar approach, designating each run with a green circle (easy/conservative), blue square (moderate) or black diamond (hard/aggressive). A skier that chooses a path misaligned with their desire, need or ability ends up with a suboptimal result, at best.
In the example below, we have two portfolios going through a market rise and subsequent market decline. Portfolio A is invested less aggressively than Portfolio B.
Everyone wants Portfolio B when markets are rising, but Portfolio A when markets decline. We all know that consistently achieving such a result is nearly impossible in the investment world, yet many people can’t help themselves from trying.
Portfolio A is a diversified portfolio and earns 10 percent during the market rise, then declines 10 percent when the market drops.
Portfolio B is a concentrated stock portfolio that earns 50 percent during the same market increase, then falls 50 percent when the market declines.
To the untrained eye, the simple average return for those two periods is identical.
|Period 1||Period 2||Simple Average|
During period 1, investor B gives himself a pat on the back and is praised as a genius at cocktail parties. Everyone wants investor B’s advice, and he can’t talk enough about his investing prowess.
Investor A, meanwhile, is overlooked as being a conservative, “vanilla” investor. What she understands, however, is what really happens during times like period 2.
|Period 1||Period 2||Simple Average||Actual Return|
If each person invested $100, Portfolio B gains $50 during period 1, leaving him with $150. The subsequent 50 percent decline then leaves him with $75, or a loss of 25 percent.
Portfolio A, on the other hand, gains a “modest” $10 during period 1, leaving her with $110. The subsequent 10 percent decline leaves her with $99, or a loss of 1 percent.
The mathematics of compound interest are almost universally discussed in the context of upside. For instance, earning 7 percent for 30 years will yield you “x” while earning 9 percent will yield you “y.”
An even more important discussion, however, should center on the impact of large losses and how the volatility of returns can affect the actual result.
A 10 percent loss requires an 11 percent return to break even, a 20 percent loss requires a 25 percent gain, and a 50 percent loss requires a 100 percent gain.
In other words, big negatives impact performance far more than the equivalent upside.
Like the skier we see gracefully tracing through a wooded area that we wouldn’t even know how to find, we all love the stories of outlandish investment success. Sometimes we can’t help but think, why not us?
Stretching for yield in a low-rate environment, abandoning underperforming asset classes or making guesses about what lies ahead are sure ways to increase the potential for a large loss.
Diversified portfolios have lagged the widely followed U.S. stock indexes, but they should still pack a nice blend of horsepower and stability to provide a very enjoyable ride. Stay in your comfort zone and remain committed to the level of risk appropriate for your personal goals and objectives.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2014, The BAM ALLIANCE