When planning a journey, reaching your destination on schedule, and with all of your belongings, depends less on how many steps you take or on how big your steps are. Rather, the key lies in the timing of the sequence of your steps (i.e. did you take your backward steps early in the journey or as you were approaching your destination?) and keeping your backward steps as small as possible. In planning your trip you know you will get side-tracked. You just don’t know when and for how long. Avoiding big delays, especially as you get close to your destination, is critical.
This basic principle is extremely important in wealth management and can significantly influence the success of your investment journey. One can increase their chances of arriving on time and with adequate capital by understanding concepts known as sequence of returns and winning by not losing. These are not new ideas, but have become exceedingly critical in today’s volatile investment world. Markets like what we experienced during the past 10 years have been labeled the lost decade and have led financial advisors to lament “there was nowhere to hide” and “asset allocation no longer works.”
To bring home the point of winning by not losing let’s look at the following hypothetical illustration. Option 1 is an investment alternative that closely correlates the S&P 500 (that is, it’s positive and negative returns match that of the broader market). Option 2 utilizes various hedging strategies and non-correlated asset classes and is designed to capture roughly 75 percent of the upside of the S&P 500 and only 20 percent of its downside. The various hypothetical returns are illustrated below:
- 2006 Option 1 +15.8% vs. Option 2 +12.8%
- 2007 Option 1 +5.5% vs. Option 2 +9.9%
- 2008 Option 1 -37% vs. Option 2 -11.9%
- 2009 Option 1 +26.5% Vs. Option 2 +12.8%.
During this time a hypothetical $100,000 was worth $97,321 in Option 1 and $123,172 in Option 2. Because it did not decline nearly as much as the market did in 2008 the non-correlated strategy didn’t require the strong gains of 2009. In other words, if you don’t step too far backward, there is no need to try to leap far forward to get back on track.