The importance of protection against a market drawdown

authored by
Christos Alonistiotis
20.01.2021
Planning for Retirement
6 minutes read

Significant Findings

1. Reducing the maximum portfolio decline has a greater impact on overall return in the long run, compared to participating in the overall rise of an uptrend.

2. Investors who are close to retirement at the moment should seriously consider the possibility of small downturns as they may not have the time needed for the portfolio to recover.

3. Smaller downturns in the investment portfolio mean easier and faster recovery of investments, after the period of decline. Smaller losses in a portfolio lead investors to a significantly better position to create investment value when markets return to "calm waters".

Investors pay close attention to how they make a profit from an aggressive portfolio, but avoid focusing on profits that can be achieved by a more defensive addition to a portfolio. Investment psychology prevents an investor from choosing investments, which in an upward market may have a lower average annual return. In this way, investors focus more on the gains of an uptrend, but ignore the necessary protection of their funds in times of strong downtrends.

Investors usually underestimate the important role of protecting their portfolio from large downturns. And yet, it is this parameter that determines the achievement of the best possible long-term result. However, the ability to minimize the inevitable losses that accompany an investment is actually more important in the process of achieving the desired goal and not if the investor has managed to "win" any growth rate of a strongly bullish market.

Avoiding big losses is more important than making a profit

Falling markets are inevitable for anyone investing in the long run and this is something that all long-term investors must accept. However, the way a portfolio handles these falling markets is crucial to achieving an investor's goals.

Strοng downward markets create "holes" from which the portfolio must emerge and return to previous levels. The higher the losses, the greater the future returns required for the portfolio to cover all losses and return to previous levels. Let's look at it using simple math: A 10% drop requires an 11.1% rise to return to zero (initial level). A 25% drop requires a 33.3% risefor the portfolio to recover. A 50% drop requires a 100% rise.

At XSpot Wealth, we fully understand how important it is to minimize the losses of our portfolios when downturns occur. Because we know in practice, that this is the most important part that leads to achieving better returns for our investors in the long run. The chart below captures XSpot Growth Portfolio which is structured to have constant "defenses" against a possible drawdown of the markets, as well as the SPY ETF, with which an investor incurs 100% of the rise and 100% of the fall.

By adopting an investment profile that perfectly combines offensive and defensive investments, in the long run, an investor can enjoy a better result by achieving significantly lower fluctuations.

In the above chart it becomes clear that minimizing the possible downturn of a portfolio, leads faster to higher levels, protecting the investor from "lost" years. The market crash of 2020, for example, condemned a portfolio following S&P 500 to three "lost" years.

Small losses in a portfolio have great psychological benefits to an investor. This is because they protect him from the psychological pressure of severe losses that leads to wrong decisions, at the wrong time, resulting in the derailment of the investment process, which requires a clear plan and sobriety.

The investment time determines the right choice of risk

Returning to the "point 0" after a decline in the value of the portfolio is a complex process as it depends on the interaction of two parameters: a) the maximum decline and b) the Average Annual Return.

Younger investors, who can take on more risk exposure and therefore higher expected returns, do not have to worry about recovery time. Older investors, who can tolerate less risk, should be careful as massive losses could provoke capital losses as they approach retirement age.

Scenario 1: A portfolio with a 25% decline and an Average Annual Return of 10% takes 2,9 years to make up for the losses.

Scenario 2: A portfolio with a 15% decline and an Average Annual Return of 4% takes 4,1 years to make up for the losses.

Investment Conclusion

Investment strategies that prevent large losses and at the same time increase the Average Annual Return, are essential in any investment portfolio. Smaller losses lead to faster capital recovery. Smaller losses deter the investor from making wrong moves under the weight of psychological pressure.

An investor needs to feel confident in his portfolio and this requires knowing, especially the part of the investment that takes on the critical role of protection, just when it is needed.

This document does not constitute and shall not be construed as a prospectus, advertisement, public offering, or placement of, nor a recommendation to buy, sell, hold or solicit, any investment, security, other financial instrument or other product or service. This document is for general information only and is not intended as investment advice or any other specific recommendation as to any particular course of action or inaction.