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 real 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 more recent 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 no longer at historic lows and the prospect of an increased inflationary environment as a result of unprecedented fiscal stimulus, wars and supply chain disruptions, the correlation between equities and bonds may not behave as they have over the last twenty or so years. The chart below illustrates the longer term relationship between the two asset classes. As is obvious, prior to 2000, there were numerous instances where the price movements exhibited highly positive correlations. The old saw that “history does not repeat itself, but it rhymes” may become increasingly apropos as we emerge from the COVID induced hangover.
As the chart below makes clear, rising rates appear to have changed the more recent landscape, and certainly through the first four months of 2022 reversed the cushioning effect of a fixed income allocation on equity holdings, with both being in negative territory year to date.
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:
We do not profess to have a crystal ball and are not in the business of predicting returns on bond holdings. The Fed has indicated it intends to raise rates and combat inflation as aggressively as necessary. Under such a scenario, 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.
Investing involves risk. Principal loss is possible.
This information is provided for informational purposes only and does not involve the rendering of investment advice. This is not an offer to sell or a solicitation of an offer to buy an interest in any investment fund, instrument or financial product, or for the provision of any investment management or advisory services. Recipients should not rely on this material in making any future investment decision. This Commentary should not be regarded as a complete analysis of the subjects discussed. Little Harbor Advisors, LLC (LHA) makes no representation that any strategy would be appropriate for any particular investor. All expressions of opinion reflect the current view of LHA as of the date of the original use of this information and are subject to change. While LHA uses reasonable efforts to obtain information from reliable sources, it makes no representation or warranty as to the accuracy, reliability, or completeness of any information prepared by another party. There can be no assurance that either strategy will continue to hold the same positions or percentage of instruments described herein and each strategy may change any position at any time.