PP3: Limit Your Downside

One common investing adage is “Don’t lose”. The reason for this piece of advice is that losses can be disastrous, both financially and psychologically. Financial markets are dangerous places with lots of nasty stuff like hidden risk, sudden crashes in value, and a general attitude of dog-eat-dog. The distribution of returns means that most of the changes in value occur over very short time horizons. The sequence and timing of these returns also matter just as much as their sizes.

All this stuff makes some people think that one should invest to never experience a negative return at any point in time. This is the wrong approach. “Don’t lose” is correct but the context is important. One must minimise the chances of losing whatever game you are playing. If a trader has to ensure his P/L is positive for a given year, he mustn’t take risks that make this a possibility. If you are saving for retirement, you have to avoid taking risks that might make your pot worth a lot less than you need it to be worth when you need to access it. Everything is context-dependent.

In our context, losing is negative real return.

Two things are important but not immediately obvious here. Firstly, real return (meaning, adjusted for the cancerous effects of inflation) is the only thing that matters…really. You can’t park your money in a Barclays checking account earning 1% for 30 years. Inflation will ruin you. Secondly, note the importance of investment horizon (the period that returns are assessed over). A portfolio constructed with downside risk in mind for a 1-month investment horizon will look very different from one constructed for a 30-year outlook. Both of these will be different to the portfolio used when investment horizon is unknown (or non-existent).

Safety first

When constructing a portfolio one must think first about downside risk. No, I didn’t say think only about this downside or think constantly about this downside. Focus on limiting the probability of a disastrous outcome as much as possible, then think about things that are more fun to think like your upside, what you are going to have for lunch tomorrow, and who is going to be in the Lions squad to play against South Africa this summer.

One should consider downside risk first primarily because portfolio construction should be about preserving (real) wealth, not creating it. If you want to make money, go and make money. Don’t try and get lucky by taking imprudent risk with your life savings. No, you’re probably not an amazing investor, so don’t act like you are. You wouldn’t fund late-night jaunts to Grosvenor with your pension, would you? Don’t gamble it in the financial markets, either.

Paranoia

I lied to you at the start of this piece. I said you shouldn’t obsess over downside risk, which isn’t strictly accurate. You have to be initially paranoid about these risks. Think government bonds are 100% safe? Wrong. Inflation can fuck you up and/or the government can default on its debt. Stocks always go up in the “long-term”? Not necessarily. House prices always rise? Think again.

Other crazy shit can happen like the government seizing your assets, pound sterling becoming significantly devalued, gold becoming worthless, etc. We must consider these worst-case scenarios (downside risk) when building our portfolio. In fact, these should be the primary considerations. The question then becomes which of these can be mitigated/controlled and at what cost.

Upside

Thinking about risk from this perspective is a consequence of thinking about assets and portfolios in terms of upside and downside in general. If probabilities are largely unknown and we are faced with a lot of uncertainty, we must focus on outcomes rather than the probability of these outcomes. The former is significantly more graspable than the latter.

We should investigate more thoroughly the payoff structure, rather than obsessing over probabilities.  For example, we don’t know whether government bonds will out-perform shares over the next 30 years (although, we do have reasons to suspect they might). However, we do know the payoff structures of, say, 10-year GILTs and shares of Lloyds Banking Group Plc. 10-year GILTs deliver fixed payments, as well as the return of principal. The upside is therefore limited and the downside is largely characterised by the risk that the government defaults on its debt (as well as inflationary concerns). The downside risk of owning Lloyds shares is that Lloyds could go bankrupt, or just simply become less valuable. However, it could also become significantly more valuable with no real limit on upside. We know the payoff spaces.