Posted on July 9, 2013 by David Laidlaw
If we compare two sample portfolios, one with returns that alternate between -20% and +20% on a yearly basis over a 10 year period and the other with returns of -10% and +10% alternating over the same 10 years, will the returns differ at the end of the period? At first glance, no, since 20% plus -20% and 10% plus -10% equal 0%. But, due to compounding, the total return varies dramatically. A $1 million dollar portfolio falls to $815,000 over a 10 year period when alternating between -20% and +20%. A $1 million dollar portfolio falls to only $951,000 over a 10 year period when alternating between -10% and +10%. The dichotomy is caused by the smaller asset base from the 20% fall. In the first year, the 20% portfolio falls to $800,000 while the 10% falls to $900,000. When the portfolio recovers, the account that fell and grew by 20% rebounds to $960,000 vs. $990,000 for the 10% portfolio. The 20% portfolio never really recovers.
In reality, the market does not work this way, thankfully, and returns are positive much more frequently than negative. Over the last 10 years, the market has been up in 9 of those years. On a month-to-month basis, though, negative returns are more frequent, and limiting the down side is much more valuable.
Our portfolios exhibit limited volatility relative to the market. Since 2000, the median monthly return for our equity portfolios when the market is up is 86% of the market (i.e. when the market is up 1% our portfolios are up 0.86%) and 77% of the market when the market is down (i.e. when the market is down 1% our portfolios are down 0.77%). As a result, our portfolios have out-performed the benchmark over that time period.
There are a few more benefits to this investment style beside the better long-term returns. Reducing volatility reduces the impact of withdrawals – the asset base is larger from which to withdraw. There is the positive psychological benefit whereby limiting the pain during bear markets helps avoid panic selling when the market is low. Academic research has also shown that low volatility stocks outperform high volatility stocks across all markets, despite the Capital Asset Pricing Model & the Efficient Market Hypothesis. This is known as the low-volatility anomaly. For an example of such research, see “Low Risk Stocks Outperform within All Observable Markets of the World” by Nardin L. Baker and Robert A. Huagen, April 2012.
This investing style is not as exciting as chasing momentum stocks. Our portfolios have limited exposure to high fliers like Tesla Motors and Pandora. Instead, we have stocks with strong fundamentals that generate cash, which should perform when the market is up and outperform more speculative portfolios when the market falls. Over the long-term, asset bases will grow and returns should be better.