Have You Got It All Wrong?

In the sports world, the team that scores the most points, wins. One could also reverse the coin, and say that the team that gives up the fewest points wins. From a fan’s point of view, the focus is usually on the former (offense) and not the latter (defense). However, as legendary football coach, Paul “Bear” Bryant once said: “Offense sells tickets, but Defense wins championships.”

The same can be true for investors. Cocktail party conversations invariably center around the big gainers (offense), and almost never around the losses. However, avoiding the big losers (defense) is generally the key to winning investment “championships”.

While the mathematics have been well publicized, it is useful to recount them here: a 100% gain is wiped out by a 50% loss. Similarly, a 50% loss requires a 100% gain to get back to even. While the figurative homeruns and strikeouts are the flashy parts of the game, they invariably dilute one of the most underrated aspects of investing: the power of compounding. The secret to maximizing terminal wealth is not so much making more on the way up, but losing less on the way down.

There are a number of ways to achieve that goal. One can utilize overt hedges: options, short positions, going to cash and uncorrelated assets to name a few. Purchasing “insurance” can be expensive, such as in the case of long option positions, where premiums can add up quickly over time. On the other hand, reducing risk by raising cash, for example, may result in opportunity costs – especially in the low rate environment we have endured for some time now.

Uncorrelated assets, largely the province of the alternative investment space, offer some hope for those concerned about capital preservation, but not willing to concede the lack of returns of some of the above mentioned choices or disinclined to pay the price of more direct hedges. Diversification has been considered as the only “free lunch” in finance. Correlations between and among asset classes can fluctuate, however. While some investment “regimes” can persist for years or decades, and the ability of different asset classes to offset risk in others may not always follow historical patterns.

Consider the following:
Traditionally, interest bearing securities have been used to help mitigate the dips in equities. Hence, the classic 60/40 portfolios that have become ubiquitous benchmarks. With yields at historic lows and the prospect of an increased inflationary environment as a result of unprecedented fiscal stimulus, we have already seen an increase in the correlation between fixed income instruments and equities.

Because portfolio returns compound over time, adding a non-correlated asset to a portfolio (“Asset B” below) can improve overall returns even if the non-correlated asset itself underperforms the other components in the portfolio (“Asset A” below):

This can also be true even if the non-correlated asset loses money:

Fixed income may not provide the cushion it has in the past. Liquid Alternatives in the form of separate accounts or ETFs may help fill the bill.