Rule #1 – Avoid major losses

If you abide by rule number one, everything is made easier. By everything, we mean the ability to generate sufficient returns and compound wealth.

This will be a short note...a reminder of the risk that grabs our attention, and the actions we are constantly taking to mitigate it. In this period of extreme economic & political uncertainty – we are hoping this brings some welcomed relief. If you find this article helpful, we suggest you read our full whitepaper, “Drawdown Patrol Investing”, available on our website.

The Marriage of Risk and Return

This relationship won’t break. In fact, it can’t break. There’s no way to find investment returns without assuming risk. But as Benjamin Graham says, “The essence of investment management is the management of risks, not the management of returns.”

Risk can be defined in a myriad of ways, but the risk that worries those of us at Aptus the most is drawdown risk. It is our opinion that all other forms of risk pale in comparison when sizing up the importance and impact on an investor’s outcome. Why? Because of two things - behavior and math.

Behavior

An advisor can estimate an investor’s risk tolerance and risk capacity. The problem is those things change. If you had $1,000,000 in the S&P 500 on February 19th – on March 23rd, you would have been holding nearly 35% less. Think about that. In four weeks, a $350,000 loss. It would take nerves of steel for most of us to not have some level of concern.

From a behavioral standpoint, nothing can throw a well-laid plan off course like a large drawdown. As we say, the path from point A to point B matters. The smoother the better.

Math

Large losses crush your ability to compound capital mathematically.

One way to think about this is through length of recovery. The more value lost, the more time it will take to recover.

Another way of thinking about this is through the law of percentages. It simply states that losses can hurt more than gains help. Let’s take a look at a simple example using some actual numbers from 2020:

Assume you lose 35% and then gain 35%. Because you are losing 35 on a higher base and earning 35 on a lower base, you end up in the hole still down 12.25%.

-$1,000,000 * (1 - .35) = $650,000

-$650,000 * (1 + .35) = $877,500

-Starting Value of $1,000,000 – Ending Value of $877,500 = Loss of $122,500

Our Portfolios

Uncertainty abounds, and we could list the reasons for that, but what’s more relevant is what we are doing about it.

We are not trying to time the markets by holding cash. The markets have shown us, in short order, the magnitude of lost opportunities that holding cash can represent.

What we have done is build more exposure to holdings that we think can benefit from volatility rising. Owning hedges was a huge help in the February-March drawdown, giving holders the opportunity to take advantage of volatility spiking and markets dropping. Our portfolios are now back to a more defensive position than we can recall them ever having.

We’re aware that risk and return are a packaged deal. We will experience losses at some point. Losses don’t scare us. Large losses do. We are positioned accordingly as we move into the latter part of the year.

If you’d like to see any type of stress test or scenario analysis on your portfolio, ask! Words are one thing, seeing the math of worst-case scenarios is different. Those numbers should bring a sign of relief.

As always, thank you for your trust and don’t hesitate to reach out with any questions at all.