Investing Involves Uncertainty. The Trick Is To Manage Risk

You Can’t Change My Mind On This One

I don’t mean to sound the broken record alert, but I want to highlight something I wrote in a recent blog.

Pullbacks happen. All the time. It’s the cost of admission into the Investing Theme Park. Turn off the fucking financial news stations and be financially unbreakable – raise the cash you need when the markets are up, so you don’t have to sell assets when they are down. Yes, I’m a CFA Charterholder, and sometimes I like to use bad words to get your attention.

In fact, I’m not even going to link to the blog (OK, yes I will…here it is) because that was the blog. There were some charts, so it’s still worth going back and looking at, but I want to punctuate the point I was making given the continued sell-off and the recent market volatility.

In case you haven’t read a financial services industry disclosure lately, it says something along the lines of this: Investing involves uncertainty.

That may sound like a bad thing, but not only is it a good thing, it’s the whole damn point because anything certain will earn about as much of a return as a dollar bill under your mattress.

You have to assume risk to compound growth over time, again, which is the whole damn point of all this.

The trick is how you manage and reduce the risk.

Again, broken record alert: the best hedge against risk is the cash you need to fund 12 to 18 months of the things you need, so that you do not have to sell assets when they are trading down.

Now, people will argue that cash is subject to a negative rate of return after inflation. They are not wrong, but I will counter that all other vehicles that provide hedging for risk (like options) probably cost more than that, even with today’s inflation. Coupled with the emotional stability that cash provides, it’s my preferred method for managing risk.

I will entertain debate, but you will never change my mind.

With that all said, it’s important to remember a few things when assessing current market volatility and the emotions that go along with seeing your portfolio go down from an all-time high.

1. Since 1980, the S&P 500 has had positive calendar year returns 32 out of 42 years…that’s 76% of the time.
2. Over those 42 years, the AVERAGE decline from peak to trough is -14%.
3. From January 1, 2020, to January 1, 2022, the S&P 500 index return was 224%…READ THAT AGAIN.
4. As of this afternoon, the S&P 500 is down roughly 11.7% year-to-date…or in other words, for some perspective, the S&P 500 is at the same level it was on July 20^th, 2021.

So…investors in the market (using the S&P 500 here) have a 76% chance of positive returns in a calendar year. We are down 11.7% compared to an average drawdown of 14%, and that’s off a 224% return over the last two calendar years.

I’m not dismissing the pain and anxiety this market is causing, nor am I saying it won’t get worse. It may.

But don’t lose your head here.

If you could get a 76% chance of winning at blackjack, you’d stay there all year, never leaving the table.

You would expect to lose an average of 14% from your stack of chips at some point, and the fewer chips you had when that happened, the more you’d feel it.

But if you were sitting there since January 2020 and grew your pot of chips by 224%, you probably would not even feel -11.7%…or even -20%.

It’s impossible to have a portfolio where you are protected from all of the different risks. You cannot have a portfolio that protects you against down markets, rising rates, catastrophes, recessions, expansions, deflation, down markets, falling rates, increasing oil, decreasing gold… you get the point.

The closest thing to a portfolio that protects against all that is cash.

It’s all about accepting compromises. The most basic example of this concept is the compromise or tradeoff between time and compounded returns. You are trading time for returns. It’s synonymous with trading liquidity for returns.

What I’m trying to express is that there is no perfect portfolio, and there is no proverbial “brass ring.” Investors who come to grips with this are likely to be emotionally capable of creating a portfolio that leverages the high probability of being right.

When the probabilities are in your favor, and you sprinkle in the benefit of letting time do its magic, you have positioned both yourself and your portfolio to do the most significant amount of good.

If I still have any doubters…if there are folks out there saying, “But there are new facts, the war, inflation, oil, and (on and on and on),” I say this:

There are always new facts. There is always a new “But what about…” to surface.

But the answer is here…

This first appeared on Monument Wealth Mangement.

Related: The 3 Mistakes You’re Making With Your Investment Objectives