How to avoid permanent loss of capital

Jan 13, 2022

Investing is all about taking risk. To achieve our investment objectives and enable investors to meet their goals, we need to assess the investment environment and take what we deem appropriate risks.

Sometimes the opportunity set will be rich, and we will be able to build robust portfolios that should comfortably meet an investor’s investment objectives. Other times, that’s not the case.

The Morningstar Investment Management team has come out with a report on how to position portfolios for 2022.

The detailed report with visuals and data can be accessed hereBelow is an extract by Matt Wacher, the chief investment officer for Asia Pacific. 

Not all drawdowns are equal.

Calling drawdowns good or bad is somewhat flippant. Of course, no drawdown is good for an investor. This is especially the case for investors with shorter time horizons.

Volatility provides investment opportunities—the ability to get set in assets with significant upside. As investing great Bill Miller says, “volatility is the price you pay for returns” and accepting volatility will be necessary for most investors. There are two types of drawdowns: 1) valuation-induced drawdowns, and 2) volatility-induced drawdowns.

How can you both protect and earn?

The best pathway is to identify the assets with the greatest reward-for-risk and size them appropriately to manage total portfolio risk. Today, the most attractive holdings are concentrated in cyclical areas of the market, despite their higher volatility, so we employ portfolio construction techniques to offset or temper the cyclical risk, including defensive sector exposures.

Our analysis hints that the path ahead could be a little rocky at times. The opportunity set has clearly narrowed. Equity markets have become more expensive on almost every measure, with some parts of the market moving to what we’d consider quite extreme levels. The same can be said for traditionally defensive assets, with bonds trading at levels that could lead to significant capital losses, especially with economic growth remaining a tailwind and inflation at levels not seen for many years.

Our analysis has shown some of the most attractive assets include emerging-markets debt, consumer-staples stocks, healthcare, and utilities companies. These are all attractive as replacements for growth assets in an array of different environments we might face, especially where the opportunity set is diminished and the potential for a risk event is elevated.

Analysis we have recently carried out shows that each of the asset classes named above have inviting downside- and upside-capture ratios against the S&P 500, presenting particularly attractive asymmetry between the two in the significant market scenarios we have run.

Key takeaways for risk management

  • The hardest, yet most effective, approach when protecting against loss is to distinguish between volatility-induced setbacks and valuation induced losses. Periods of volatility will come and go, which are scary at the time, but they rarely impact goal attainment. Valuation-based drawdowns (paying too much for an asset) can be more enduring and may not be fully recouped—even over the long term.
  • Resist impulsive actions and understand that the road won’t be straight. Accepting some volatility is a pre-requisite for good returns in any market, but today’s market arguably requires greater care than usual.
  • When it comes to downside protection, you should be happy to forego some of the gains in strong upwards markets, acknowledging that you won't participate in losses to the same extent as others if you maintain a risk-focused approach.
  • If you can limit losses by investing in a risk-focused way, you are less likely to act irrationally. Meaning, you are more likely to stay invested, and have a better chance of achieving your goals over time.

Access the detailed report with visuals and data.

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