Suppose, in mid-2000, John, an investor with results similar to this tempered index, became so disenchanted with his perceived opportunity cost over the first 4.5 years that he abandoned his risk-managed portfolio in favor of one that simply followed the untempered index. His subsequent return over the next 15.5 years would have been a cumulative 90%. Meanwhile his sister, Jane, who stayed faithful to the risk-managed approach, enjoyed a cumulative return of 191% over the same period. And Jane, of course, ended up much wealthier after the full 20 years, having seen a cumulative growth of 476%, compared to her brother’s 276%. In dollar terms, John grew his original $100,000 portfolio to $376,000 (see dotted line path on graph above), while his steadfast sister, who also started with $100,000, grew her portfolio to $576,000 (see red solid line path on graph above). John got in his own way and deserted a proven, time-tested risk management approach simply because it wasn’t needed, in retrospect, over the short term.
We noted how, through the first 4.5 years, i.e., from 1/1/1996 through 06/30/2000, an investment in the non-risk-managed S&P 500 Index would have done better. This will typically be the case when the untempered index is in relentless upswing. We have seen recent examples of investors who have grown impatient with risk-managed investing when facing a similar situation. That is why this approach rewards only those investors who have the patience and fortitude to see it through a complete market cycle and rewards such investors further through each subsequent cycle.
So, a portfolio risk management device that mitigates extreme percentage movements can lead to greater wealth creation over time than a portfolio without such a device. Are there such devices in practice? We will discuss several practical approaches in subsequent articles.
These approaches constitute a class of strategies that we call Risk-Managed Investing, or RMI, which we introduced in (Article One) and further discussed in later installments (Article Two, Article Three, Article Four). Each RMI strategy attempts to mitigate downside risk, and each has a cost, which directly or indirectly sacrifices some upside potential. Some RMI approaches are more cost-effective than others in this regard.
In our next installment, we will address a question to which the above discussion logically leads: How much market upside should you be willing to give up to achieve a given level of downside risk mitigation?
For now, the thought we would like to leave you with is this… RMI has the potential to be a powerful wealth-building tool for those investors with the foresight to appreciate its potency and the patience to let it work for them.
Please let us hear your comments.
This material is for informational purposes only. Nothing in this material is intended to constitute legal, tax, or investment advice. Investing involves risk including potential loss of principal.