The Upside of Downside Protection

Investing success is always a hot topic, even more so when financial markets are rallying. Tales of big wins in strong markets, top-performing stocks or the high-flying tech sector are probably easy to come by. Less exciting for investors to consider is downside protection and why it should be a key attribute in any investment portfolio.

Downside protection is a risk-management strategy that attempts to reduce the frequency and magnitude of losses in your portfolio.

If your portfolio needs to recover from a loss, it’s not compounding wealth—it’s just playing catch up. Downside protection strategies can actually contribute to a positive rate of return: they’re designed to help your overall portfolio spend more time compounding than it does recovering from losses.

The key concept behind compounding is that the earnings generated will generate even more earnings, and investors can see their investments grow faster and faster as the years roll on, like a snowball effect. The benefits of compounding might not be obvious in the short term, yet can make a big difference over the long term. The power of compounding is not only evident in upside gains but is also remarkable in downside protection.

In the investing world, because the less you lose, the less you need to recover, 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 grow the upside but it is arguably even more important to protect the downside.

Multi-asset investing is a growing trend for investors who are looking to participate in up markets while keeping a close eye on downside protection. Multi-asset investing seeks to take advantage of the benefits of dynamic allocation and effective diversification. A wellmanaged multi-asset solution can also use best-of-breed investment managers and strategies in a broad range of asset classes, with the goal of generating the extra performance that is vital in a world of low returns.

Multi-asset solutions can provide a measure of downside protection through a variety of strategies:

  1. Diversifying into non-traditional sources of return, such as infrastructure, real estate and commodities. These tend to be non-correlated to other assets and can provide an element of downside protection through yield and the intrinsic value of tangible assets.
  2. Reducing allocations to volatile assets, through investing in defensive securities that have tended to have lower earnings volatility and stronger balance sheets.
  3. Dynamic portfolio management that seeks to capitalize on market dislocations to either enhance returns or manage risks.

Why Is Downside Protection So Important?

Because it is hard to recover from big losses. For example, if your portfolio suffers a 30% fall, you need a 43% rise to recover your starting level. This is where we believe a multi-asset approach is valuable. To explain why, let’s recollect Aesop’s fable about the race between the tortoise and the hare. In the original story, the tortoise beat the hare by being more consistent. In our version of the story, we race two portfolios. One has a lower average annual arithmetic return (runs slower) but is widely diversified and so exhibits lower volatility. Let’s call this one multi-asset. The other has a higher average arithmetic return (runs faster) but is concentrated into a singleasset class, higher-volatility portfolio. Let’s call this one equities. Although the multi-asset tortoise on average runs more slowly, it keeps going, while the equities hare enjoys an initial sprint in our hypothetical example, but then trips and falls behind for a while, before regaining its stride. Because the low-volatility tortoise has fewer and/or shallower setbacks to recover from, its lower average returns can compound more smoothly. That’s why the multi-asset tortoise has a good chance of matching or beating the equity hare over one or more full market cycles, all other things being equal.

For illustrative purposes only. Does not reflect the performance of any Russell Investments Canada product.

This becomes more important the closer you are to retirement. As the number of years you have available to save become fewer, the more limited your investment horizon and the higher the risk of being unable to recover lost ground. This investment concept is called sequential risk.

Sequential risk is another term for the threat of bad returns at a highly critical time. For a typical Canadian investor, that time occurs in the few years prior to and immediately following retirement – exactly the point the first wave of Baby Boomers is at right now. Just prior to retirement, their assets have peaked and their ability to save further is limited. A downturn in investment returns in the period just after retirement could compromise potential planned withdrawals for many future retirement years. As the hypothetical diagram below shows, sequential risk is highest just before and just after the retirement date.

While volatility is a normal part of investing, its impact on your portfolio gets more adverse once you start making cash withdrawals. Imagine what happens as a retired person if you suffer a 30% fall in your portfolio value, and then discover you need to buy a new car, or make a major home repair, or simply require regular income during the initial years of retirement when you are most active? You may have to take cash out of your retirement plan at the worst possible time, and even if your returns in the subsequent years are strong, you may never get back to your starting level.

It’s important to remember that while financial markets have gained over the long term, there have been numerous periods of extended drawdowns and no one knows what the future will bring. Markets are unpredictable. If you’re an investor concerned about building long-term wealth, you may want to consider a portfolio with built-in downside protection strategies and money managers focused on helping smooth returns. That could go a long way to preserving the power of your portfolio.