Why Protecting in Down Markets is More Important Than Participating in Up Ones

In my last piece I wrote in May, “Sandpiles & Bridging Market Uncertainty,” I stated that to understand the law of compounding money is to understand that the degree to which you protect capital loss in down markets is much more important than the degree to which you grow capital in up markets.  In this piece, I will get into that in a little more detail using real life examples.

Before we get into it though, it’s important to clarify my statement and the title of this piece. We are not saying that participating in up markets is not important – it absolutely is.  What we are saying is that in order to compound money at a steady rate over time, an investor does not need to capture all of the upside of the market in good periods if he is protecting himself from considerable downside in bad periods.  Some of the smartest financially savvy folks I know overlook this. Let me give you an example to highlight my point. Take a look at Investment A and Investment B below.  Which investment made more money at the end of the two year period?

For example, Think of negative returns like digging yourself a hole.   The more negative the return, the deeper the hole you dig for yourself and the harder it is to get out. Another way to say this is that the more negative the return, the higher the return must be to get back to break even and continue growing your investment again. A negative 10% return requires just an 11% return to get back to even, a negative 20% return requires a 25% return to get back to even, but a negative 40% return requires a 67% return to get back to even, while a negative 50% return requires a 100% return to get out of the hole!

Investment A represents that of a prudent investor.  He uses flat to up markets (i.e. Year 2) to grow his portfolio.  His portfolio during these periods will often not capture all of the upside of the market.  Nevertheless, he outperforms his peers over a full market cycle (i.e. a bull market and a bear market), because he protects capital so well in down markets (i.e. Year 1).   This is the type of investing we favor at Beacon Pointe.   Not only does it grow capital over full market cycles, but it does so in a way that minimizes risk (and anxiety!) while allowing clients to meet their investment goals.   Most investment strategies can make money when the market is going up – that’s easy.   The few great strategies, however, are those that avoid giving most of it back in down periods.

As the well known Warren Buffett says, “You don’t know who’s swimming naked until the tide goes out.”

~Graham Pierce, Managing Director – Private Client Group

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