Broker Check

The Upside of Downside Protection

| October 22, 2018
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Tompkins Financial Advisors Investment Committee

As the current 9 year bull market rages on, some investors may experience FOMO, or the fear of missing out, and dial up their risk exposure in an attempt to capture more upside associated with equities. But as investors dial up the risk to catch more upside, they are also in turn catching more exposure to the downside, which can have detrimental effects to a portfolio in the long run. Overtime, it’s more important to limit the downside than participate in 100% of the upside, and simple math proves it.

To break even after a portfolio drawdown, you need an even higher return. As shown below, the less you lose, the less you need to make back again on the upside.

Investment strategies that provide the potential for both exposure to the upside while also protecting on the downside can help enable investors to better weather market selloffs (both psychologically and on a relative performance basis) and beat their benchmark over multiple market cycles with less risk.

It’s important that financial advisors construct a portfolio that not only matches their clients’ risk appetite, but also employs diverse strategies that can help limit drawdowns while still participating in the upside. While most investors consider portfolio diversification to be limited to just stocks and bonds, other diversification tools that may better position portfolios to outperform during market drawdowns include: geographic diversification, factor diversification, and alternative asset classes. At Tompkins Financial Advisors, we construct investment portfolios with all of these tools in mind as we aim to win more by losing less.

Geographic Diversification

Spreading equity exposure across various geographic regions, including but not limited to the U.S., developed international, and emerging markets, helps smooth out volatility and enhance downside protection. Since business cycles that drive investment returns are experienced at different times in different countries, foreign markets rarely move in perfect tandem with each other.

History has shown that no single country or regional market has consistently outperformed over the long term, and there is no way to determine which market will outperform in any given year. Diversified exposure to a broad array of countries and regions takes the guesswork out of deciding which region to invest in (and when), while also boosting exposure to growing economies and reducing equity risk.

Source: Callan

Factor Diversification

Factor-based investing, also referred to as “smart beta” in the investment industry, is an investment strategy that ditches the traditional market-cap weighted methodology and instead favors weighting equity exposure based on style factors that have proven to generate attractive risk-adjusted returns overtime relative to the market. The most popular factor investment styles include:

Value: Value aims to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly tracked by price to book, price to earnings, dividends and free cash flow.

Growth: This factor concentrates exposure to stocks that exhibit higher historical and forecasted growth rates, as measured by fundamental measures such as earnings and sales, relative to the broader market.

Size: Historically, portfolios consisting of small-cap stocks exhibit greater returns than portfolios with just large-cap stocks. Investors can capture size by looking at the market capitalization of a stock.

Momentum: Stocks that have outperformed in the past tend to exhibit strong returns going forward. A momentum strategy is grounded in relative returns from three months to a one-year time frame.

Low Volatility: Research suggests that stocks with low volatility earn greater risk-adjusted returns than highly volatile stocks. Measuring standard deviation from a one to three-year time frame is a common method of capturing beta.

It is important to diversify your equity exposure across multiple factors, including low-volatility, size, momentum, growth and value. Specifically, low volatility and value factors have proven over time to limit market drawdowns during periods of market stress.

Alternative Asset Classes

A diversified portfolio to protect against market volatility and provide downside protection not only includes stocks and bonds, but also includes liquid alternative strategies that have low correlations to equities and fixed income. While bonds don’t offer foolproof protection due to their rising correlations during certain periods of market stress, alternative strategies can offer another avenue of portfolio diversification. One popular alternative strategy is an option collar strategy. Option collar strategies hold put options on the market, which allow them to benefit from a volatile market and limit downside performance in periods of market stress, while also holding equity positions, which allows the strategy to participate during periods of upside market performance. While the put options act as insurance and can slightly drag down performance during up markets, they can provide crucial protection during sudden and sustained market drawdowns.

Missing the Best Months vs. Missing the Worst Months

Investment industry professionals tend to harp on the data that illustrates the following: missing out on the ten best months of the stock market leads to lackluster returns, therefore you should remain 100% invested at all times. What they tend to leave out is the fact that missing out on the ten worst months of stock market performance leads to sizeable outperformance. The issue is, the best and worst months are usually clustered together during periods of high market volatility, and successfully timing the entry and exit out of the market during the worst and best months is nearly impossible.

The takeaway from this, as shown below, is the importance of limiting drawdowns, which over multiple market cycles can lead to sizeable outperformance and less risk relative to a simple buy and hold strategy. This point is illustrated in the chart below by the higher annualized return and lower standard deviation of the Miss Best & Worst 10 Months compared to the simple Buy and Hold strategy.

Source: ReSolve Asset Management. Data from Robert Shiller.

Conclusion

While most investors believe diversification can be achieved simply through a mixed allocation to stocks and bonds, Tompkins Financial Advisors believes there are more levers to pull that can enhance portfolio diversification and limit drawdowns during periods of market volatility, which over multiple market cycles can lead to significant outperformance and less risk. Tompkins Financial Advisors builds client portfolios with this in mind, incorporating exposure to fixed income and global equity markets, factor-based investing, and liquid alternatives. Contact a Tompkins Financial Advisor today to learn more about how this enhanced portfolio diversification can better serve you and your investment needs.

Investments are not insured by the FDIC, not deposits of, obligations of, or guaranteed by the bank or its affiliates, and are subject to investment risk including possible loss of principal. I recommend consistency in this disclosure across all print marketing pieces.

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