Do High Return Strategies Outperform On The Downside?

Do High Return Strategies Outperform on the Downside? by Scott England, Covenant Capital Management

It is rumored that the great Albert Einstein once said that compound interest was the “greatest invention in human history.”  It is also rumored that he alternatively said that compound interest was the “most powerful force in the universe.”  Whether he made these statements or not is really a moot point.  Compound interest is certainly a means to creating wealth.

It is clear and obvious that strategies with higher returns benefit more from the power of compounding than strategies with lower returns.  You can even invest a smaller amount in a high return strategy and ultimately end up making more money than a lower return strategy over time.  For example, an investor can take 1/5 of the risk by investing 1/5 of the money in a strategy that offers 5x the returns.  In the table below, you can see how a $10m investment compounding at 10% per year compares to a $2m investment compounding at 50% per year.

High Return Strategies

  • Total returns after 3 years:
    • Lower return strategy = 33%
    • Higher return strategy = 238%
  • Higher return strategy makes $1,440,000 more after 3 years, risking 1/5 the cash

I’m guessing that the example above probably didn’t surprise anybody.  Most likely you are thinking, “thanks Captain Obvious, but what about the downside in a strategy like this?”  Well let’s take a look at what happens to the two investments in a drawdown.  How does the higher return strategy compare to the lower return strategy?  Is the higher return strategy more risky?

High Return Strategies

  • Total returns after 3 years:
    • Lower return strategy = -27%
    • Higher return strategy = -88%
  • HOWEVER, the lower return strategy loses $960,000 more, and had to risk 5x the cash!

It is clear from the example above that higher return strategies benefit from a decompounding effect even though they have a higher drawdown potential.  If you size your investment appropriately in a higher return strategy; you can control your risk, and ultimately benefit from both compounding on the upside and decompounding on the downside.

In summary, I leave you with 2 questions:

  1. What strategy offers more downside, less upside, and ultimately more RISK?
  2. Why does everybody still want lower return strategies?

-Scott England