If the market returns around 9% on average why would I need downside risk protection? And, what is that exactly?
While the market may average 9% annual return you aren’t getting that. First, no one can achieve the average, only the returns that make up the average. Those returns fluctuate from up 54% to down 43%. Most people just can’t stomach those wild swings. So what happens? They bail too early and get in too late. Investing is the only industry where most people sell when things go on sale and buy when they are not.
The market spends a lot of time in drawdown. The chart below shows drawdowns of 5% or more nearly 50% of the time. Historically, the market has always rebounded and grown. Your performance depends on your ability to psychologically weather the storm. Or, if you need money from your portfolio during a drawdown, well…yikes.
Given enough time you might be okay. How much time? 20, 30, 40 years maybe. You just can’t say with any certainty.
We also know this volatility robs your returns over time. It’s a mathematical fact that two funds with equal rates of return but with differing levels of volatility, the lower volatility fund would have a higher compound return. Not only does lower volatility make for a smoother investment ride, but it also helps create wealth.
What can you do about it?
The largest portion of our portfolios use momentum as a factor for lower volatility and downside risk protection.
Momentum is simply using price to determine the appropriate allocation. Price works as the ultimate indicator because of supply and demand. The irrefutable law of supply and demand has been the ultimate guide to navigating markets for centuries. Supply and demand govern how prices move. Therefore, price tells the true story. For example, if there are more buyers than sellers, prices will rise. If there are more sellers than buyers, prices will fall (Dorsey, 2007).
Our belief is that markets are not always priced efficiently and that investors do not always act rationally. Since markets rarely act the way textbooks say they should, markets can and do rise and fall. Investors can and do act irrationally for long periods of time. Using price momentum to capture these waves in a portfolio makes a lot of sense. In fact, its been studied for centuries.
Our equity strategies invest in equities when they are strong, according to absolute momentum, in order to capture the highest return amount. When equities are weak, we can switch to bonds, which offer a more modest return. Since the equity market is a leading economic indicator, a weak market can indicate a future economic slowdown, declining interest rates, and a healthy bond market. Stocks and bonds may complement each other in this manner. So instead of holding them as a permanent allocation in your portfolio, we can move in and out based on the trend of the market. This also is used with different asset classes within equities and within bonds.
The Benefits of a Momentum-Based Strategy
While momentum strategies does not avoid declines, they can greatly minimize volatility and drawdowns. The beauty of momentum lies in avoiding the BIG declines. Investors have to minimize the big declines to create greater success when investing. We’ve designed our momentum strategies to minimize these large drawdowns while still being able to capture upside. Over the long term you should be able to experience compound returns and greater investment performance. Contact one of our advisors or visit explore more of our website for detailed information.
What does this really mean for you? Momentum strategies may offer a smoother investment ride, allow you to stay invested (instead of bailing at the wrong time), and enhance long term performance.