“The hardest part in trying to limit losses is not necessarily timing the market, but imparting the wisdom of limiting losses upon your clients.
To limit drawdowns advisors and their clients cannot fully embrace raging bull markets that are excessively valued.
They must also have the iron stomach required to buy when everyone else is selling and assets are cheap.”
I enjoy reading 720 Global’s research blog. Quick, crisp and to the point. The point in their most recent piece is tied to human behavioral tendencies and ego. Ultimately, it’s about how this awareness should be factored into our investment thinking.
In their piece, they told a story about NBA great Rick Barry. Do you remember him? He shot his free throws underhand, a.k.a. “granny” style. From the piece:
In 1962, Wilt Chamberlin scored 100 points in a single game, which to this day stands as a record. Less well known is, in that same game, he made 28 free throws which is also a single game record. Chamberlin, a career 51% free thrower shooter, shot 88% from the free throw line on that record-breaking night. It was not a fluke. That was the only game of his career that he shot free throws underhanded.
Despite his historic achievement that night, he never shot underhanded again. In his words “I felt silly, like a sissy shooting underhanded. I know I was wrong… I just couldn’t do it.”
Malcolm Gladwell, in his podcast series Revisionist History – The Big Man Can’t Shoot, highlights how ego, pride and the opinion of the masses can prevent us from doing the smart thing. Investing is much the same. Our brain is somehow wired to copy people… follow the herd, blend in. To act counter to the majority may prove embarrassing. Shooting granny style is silly. Except it works.
Last night at dinner, we discussed what my son, Matthew, is learning in his macroeconomics class. I was actually impressed. Such teachings are largely absent in our schools. Missed are some of the most important basics. The most important miss to me is the lack of understanding in math in how money compounds. He and his classmates now get it. Losses have to be minimized for the math to work; yet, too few think about employing a loss management process.
Why? I believe it takes time, requires discipline and requires you to do something that at times (like 1999 and 2007) require you to go against the crowd. It requires you to risk being wrong at times when you neighbor is right. Rick Barry explains why shooting underhanded is not only more natural but produces a softer shot which increases the probability of it going through the hoop. For investing, the growth is in the math and the math works when you limit your downside.
“Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.”
— Seth Klarman
In a separate piece “Limiting Losses,” 720 Global examples two simple scenarios to why limiting drawdowns is essential to building wealth. From the piece:
- Scenario A is a buy-and-hold portfolio with a 100% allocation to the S&P 500 at all times.
- In scenario B, the portfolio is also fully allocated to the S&P 500 except during the bear markets of 2000 (1/1/2000 – 3/31/2002) and 2008 (10/01/2007-04/30/09).
- During those bear markets, the portfolio had a 50% allocation to the S&P 500 and the other half was in cash. At the troughs of the downturns, portfolio B shifted back to a 100% equity position.
The graphs and table below show the cumulative total percentage return, cumulative annualized percentage return and other relevant performance statistics for both scenarios.
Source: 720 Global
“No one can time the market perfectly in the manner described in this scenario (SBB here – and I certainly wouldn’t recommend this particular process), but the point of the analysis is to illustrate just how important it is to avoid large losses. There are two big takeaways from the data above. The most obvious is the significant difference in returns over the period. After two bull and bear market cycles, scenario B’s value grew at a significantly faster clip than that of scenario A,” they noted.
It is also worth noting that from 2000-2012, scenario A’s return was negative 72% of the time over those 12 years. (SBB here — 72% of the time.) Scenario B produced positive cumulative returns uninterrupted since 2004 despite the second large drawdown in 2008 and was negative only 21% of the time. A far better emotional ride for the investor.
Further on point, “Compounding and the illusion of percentages are key factors that help explain why losses are hard to recover. Equal percentage gains and percentage losses are not, in fact, equal. This may sound confusing, but again consider an investor with $100,000. If the investor loses 25%, the portfolio value is only $75,000. A 33% gain ($25,000/$75,000) is then needed to regain the original 25% loss. The table below shows the percentage gains required to offset percentage losses. As highlighted, the gains necessary to recapture losses are manageable with limited losses but they get increasingly more challenging as percentage losses increase.”
The message is simply another gentle reminder that the ability to suppress the ego is needed if one is to mitigate the potential consequences of the current market bubble.
Source: 720 Global
Next week we’ll take another look at April 2017 month-end valuations. We’ll see the equity market remains expensively priced and forward 7-year and 10-year return probabilities remain low (estimated at approximately -2% to +3% nominal).
Rick Barry once approached Shaquille O’Neal about trying his underhand style. Shaq’s reply was “I’d rather shoot zero.” Investing requires work and to be successful, as Rick Barry pointed out, the best odds of success are doing something that may look and feel unconventional. It’s hard to go against the crowd at market extremes. I’d rather shoot 90% underhand. Or like Wilt Chamberlin, shoot 88% underhand vs. 51% average. But that wasn’t somehow good enough for him to stick with the process.
I believe a majority of investors do the same with their money. I believe if we are aware of risks, we will be better prepared to act on the opportunities that risk dislocations create. Putting a risk management plan in place is not hard to do nor does it look as silly as a grown man shooting underhand but is does require work; it requires discipline, conviction and the courage to stay on plan. Limiting losses and controlling drawdowns is paramount to successful long-term wealth accumulation.
Grab a coffee and find your favorite chair. Below I touch on tax reform and today’s low GDP number and share with you a few great charts from JP Morgan Asset Management. You’ll find several risk management processes