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It May Be Time To ‘Manage The Downside’.

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

 

Are we in a new investment environment very different from what we’ve known in the past?   

Many investors think so.  If true,  this new environment  just might require a different investment model than the one most investors are used to.    

The high volatility of the past seemed to reward being fully invested.   We had high volatility, but it was linked to high average returns.   You were rewarded for remaining fully invested in stocks.     

 This time, the environment might be different:   High volatility linked to lower average annual returns.  If that turns out to be true, the old investment model may not work very well and the real money managers will have to step forward.   

I created a purely hypothetical volatile market (20% moves each year) in Figure A and arranged the returns to begin and end with an `up’ year. I even put two `up’ years back-to-back in years 7 and 8 and even arranged for 3 out of 4 to be `up’ years at the end! The resulting average annual compound return is only 2.03%… below historic inflation figures.   You’re in a bad market, but it looks good enough – enough of the time – to keep you hoping to win.   The key to this market is limiting losses.

Figure A

Amount Invested: $100,000
     
  Market Portfolio
Year Return      A
1 20% $120,000
2 -20% $96,000
3 20% $115,200
4 -20% $92,160
5 20% $110,592
6 -20% $88,474
7 20% $106,168
8 20% $127,402
9 -20% $101,922
10 20% $122,306

   

Figure B shows the same market if an investor gives up 40% of each `up’ year and captures only 25% of the downside moves. The result is $38,463 more, despite having no big `up’ years to brag about.   So, capturing only 60% of the upside and only 25% of the downside would look like this:

Figure B:

 Amount Invested:   Up Cap> 60%  
 $100,000     Dn Cap> 25%  
  Market Portfolio Portfolio

 

         Year Return B Return       B Difference
1 20% 12% $112,000 -$8,000
2 -20% -5% $106,400 $10,400
3 20% 12% $119,168 $3,968
4 -20% -5% $113,210 $21,050
5 20% 12% $126,795 $16,203
6 -20% -5% $120,455 $31,981
7 20% 12% $134,910 $28,741
8 20% 12% $151,099 $23,697
9 -20% -5% $143,544 $41,622
10 20% 12% $160,769 $38,463

   

This is purely hypothetical, of course;  but it does seem to illustrate that if those experts are right, those who manage the downside will be the ones making money.   No more riding the waves.  

Will the real managers please stand up.

Written by Jim Lorenzen, CFP®, AIF®

July 15, 2010 at 8:00 am