Risk Management Comes in Many Flavors
Every investment manager has a different definition of risk management, but it will typically look like one of the following:
- Periodically create small amounts of cash.
- Stay invested, but asset allocate to take advantage of low volatility sectors or asset classes.
- Utilize fixed income to temper equity volatility.
- Actively rotate among cash, equities, and fixed income without constraints.
At Potomac, risk management all comes down to the mitigation and avoidance of catastrophic market losses. These are the market losses that can be devastating for investors approaching retirement (where the need for income is at its highest).
The Math of Risk Management
Americans are not good at math. Yeah I said it, the stats consistently prove this. This could be why risk management is so misunderstood in the investing world.
My favorite tool to use when discussing the math of advances and declines is also the simplest.
I am sure every advisor has seen this table below by now, but it rather eloquently illustrates how much return you need to generate to breakeven.
Regardless of how you feel about this table, the math doesn’t change. And that is the hardest thing for folks to grasp.
As I write this, I have had numerous people tell me that the most recent 2020 bear market decline of roughly -30% on the S&P 500 is “no big deal” because they made 30% last year so it’s a wash. What?!
Let’s work this math out in simple terms.
Your client starts with a $100,000 investment last year and hypothetically made a 30% return in 2019, ending the year at $130,000. Then the same client is now down -30% in 2020, so $130,000-$39,000 (-30%) is $91,000 and not the $100,000 breakeven.
This is the furthest thing from a “wash” and the client is now down roughly -10% from their initial investment.
The Bat Signal for Risk Management
Hands down the absolute best measurement of risk is maximum drawdown, which we talked about here.
To recap, maximum drawdown measures the peak to trough decline of an investment since its inception and is important for two primary reasons:
- First, maximum drawdown is easy for investors to understand—it’s all about how much pain you are willing to endure to seek returns.
- Second, maximum drawdown can’t be changed, obscured, hidden or beautified by other performance statistics. With any peak-to-trough drop in investment value, what you see is what you get. There’s no hiding or smoothing over the consequences of a significant loss.
Unfortunately, many investment products don’t report this number for fear of investors seeing such a large negative number and get spooked.