Why downside protection may matter more than upside growth

September 26, 2017 Categories: Portfolio Corner
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Downside protection

The global macroeconomics and geopolitical outlook remains uncertain, suggesting that an environment of low rate, low growth, and high valuations may linger. This uncertainty presents a challenge for investors who are looking to generate attractive returns while preserving capital during market volatilities.

Against this backdrop, preserving capital may be more important than seeking the growth of capital, i.e. downside protection. It matters, because, in the investing world, losing less means requiring less to bounce back.

In fact, avoiding losses appears to be more important than achieving gains.

The following chart shows the historical returns required to recover after a drawdown.1 The returns investors need significantly increase as losses go deeper after a period of underperformance. A drawdown of 20% would need 25% to recover, whereas a drawdown of 50% would need 100% to regain ground. This example demonstrates that a dollar of excess return in a down market is worth more than a dollar of excess return in an up market. To achieve long-term growth, it is inherently important to not only grow the upside, but it is arguably even more important to protect the downside.

drawdown

As data show, strategies that provide both potential upside and downside protection can help enable investors to weather market changes and stand better chances of outperforming benchmarks. With valuations inching higher, how can investors identify such opportunities? The key is through diversification.

In recent years, Russell Investments has consistently advocated for investors to consider a global multi-asset approach to investing for a variety of reasons, and the center of it is around helping clients take a smoother path towards their objectives. While the objectives of multi-asset strategies may vary, some are designed specifically to help provide investors with better downside protection while providing the growth they require. A multi-asset approach can help achieve these goals through three main phases:

Design: In the design phase of a portfolio, when asset allocations are established, a nuanced asset allocation may help to capture the things in-between core equity and bonds—such as bank loans, high yield debt, emerging-market local and hard currency debt, mortgage-backed securities, and other alternative strategies—that are not modeled in a traditional 60/40 fixed income and equity allocation. This differentiated approach to diversification is designed to deliver growth, and, perhaps more importantly, to minimize the big downward dips.

Construct: When the portfolio is actually built, we believe a true multi-asset approach applies a wide network of skilled, active money managers who specialize in each asset class. This may be complemented by passive exposures and specific positioning strategies to seek to effectively manage the total portfolio. By spreading such a broad net for manager expertise—well, think of it as an additional layer of diversification to help against downside risk.

Manage: After the portfolio is built, we believe a true multi-asset approach continues to dynamically manage that portfolio. This dynamism across asset classes is intended to help manage downside risk and gain exposure to high-conviction investment opportunities. This can include managing a portfolio of physical securities—such as stocks or bonds—or implementing overlay-based strategies such as options, currency forwards and futures.

The bottom lineCombining all these levers, a multi-asset approach may help investors with downside protection.

It’s understandable that so much of the world is chasing growth. Growth is enticing. But we believe savvy investors will focus on what the data tells us. And the data shows that protecting against downside just may get you more bang for your buck.

Disclosures:

1 This was calculated using mathematical principles of percentages. For example, a 10% loss of $100 is $90. An 11% gain — or an additional $10 — is needed to go from $90 to $100. A 20% loss of $100 is $80. A 25% gain — or an additional $20 — is needed to go from $80 to $100.

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Indexes are unmanaged and cannot be invested in directly.

The S&P 500®, or the Standard & Poor’s 500, is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

The Russell logo is a trademark and service mark of Russell Investments.

Copyright © Russell Investments Group, LLC 2017. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments.

RIFIS: 19122

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