Alpha Generation through Risk-Managed Investing

It has been our experience that investors pursuing “market-beating” returns largely overlook what is perhaps the single most reliable way to achieve investment outperformance over the long term.

The method is simple, and it works by exploiting an inescapable mathematical fact about the capital markets — a phenomenon that has been called the asymmetry of returns.  The method, which can be characterized as winning by losing less, is accessible to investors of all types and sizes. But it requires a deep appreciation for return asymmetry, and the patience to let this phenomenon work for you over complete market cycles.

What is return asymmetry?

Here’s an example. If you start with $100, a -10% decline (to $90) requires a subsequent +11% gain ($100/$90 – 1) to get back to break-even. Every ‐1% decline requires greater than a +1% recovery to get the investor back to where he/she started. This phenomenon occurs for declines of any size. In fact, the larger the percentage decline, the more pronounced the asymmetry, as the table below shows.

A key takeaway from this is that, in terms of percentage returns, it is more valuable to avoid a decline than it is to capture an advance of the same magnitude. Put another way, avoiding a loss is the economic equivalent of capturing a gain of even greater magnitude.  It should be clear that this has major ramifications for a successful long-term investment strategy.

If this implication is not clear, the following demonstration may help. Let’s use the S&P 500 Index to make the point, though any index with peaks and troughs (i.e., just about any capital markets index) would do.  In the graph below, we plot (in blue) the monthly total return of the S&P 500 Index over the last 20 years, ending 12/31/2015.  The average monthly return of the S&P 500 Index over this period was 0.76%; its monthly standard deviation was 4.42%. We also plot (in red) the S&P 500 Index if we temper by 50% both the upside and downside monthly deviations from the average monthly return. The average monthly return of this tempered index remains 0.76%; but its standard deviation is now 2.21%, half the original. [Technical note: This latter index is not an “investable index” as it depends on measures (such as standard deviation) that can be known with certainty only in retrospect; but it is a relevant and useful model for this conceptual demonstration, since its behavior reflects the goal of many portfolio risk management strategies.] So, what are we attempting to show with this demonstration?  We are looking to directly measure the added value opportunity presented by return asymmetry. Specifically, by tempering both advances and declines by the same degree, while keeping the average monthly return unchanged, we are able to calibrate the improvement in long-term wealth attributable solely to exploiting the asymmetry of returns.

3Let’s make a few observations from this demonstration

First, an investment that behaved like the tempered index would have resulted in substantially more wealth over the 20-year period, relative to the S&P 500 Index. Second, the outperformance is entirely attributable to periods when the S&P 500 Index is in decline. A corollary to this second observation is that, when the S&P 500 is steadily rising, the tempered index falls significantly behind. In fact, we started the comparison in the mid-1990s to highlight this fact — through mid-2000, the tempered index grows by only 98% cumulatively, while the untempered S&P 500 grows 154%.