The Most Important Investment Concept & How to Win the Long Game

This post discusses a very high level concept that is crucial to successful investing and is most applicable to the growth side of investing.  Price fluctuations don’t matter all that much when investing for income but permanent losses obviously do.  There’s a lot more that goes into portfolio construction and properly tailoring a portfolio to a client’s specific plan, goals and cash flow needs, but the concept presented in this post should be at the forefront of your mind when thinking about investing.  

Here are the historical returns of two different investments over the last 30 years (1987 to 2016).  I highlighted in green each year that one investment outperformed the other.  Which one looks more appealing to you?Interestingly, over the last 30 years, each outperformed the other an equal number of times but the end result is very different.  Those of you who are more aggressive investors might lean toward  #2 (some big up years) while those that are more conservative might think #1 looks more attractive (smaller down years).  Well, regardless of your risk tolerance, the correct answer for every investor should be #1.  If you were wondering, #2 is the Russell 2000 Index (total return) and #1 is a Russell 2000 tactical allocation strategy I developed.  Here are the return statistics:

The Russell 2000 Index has generated bigger gains during some years but also bigger losses.  The smaller losses provided from the tactical strategy generates lower volatility which helps create a higher compounded average rate of return of an additional 1.7% a year.  This may not sound like a lot but it equates to 58% more money after 30 years, which is a very big difference!  

Growth of $1 

This illustrates the difference between a simple average and a geometric average.  In investing, returns are not independent of one another, meaning each year matters and affects the final outcome, so it’s the geometric (compounded) average rate of return that matters.  The higher the volatility of a sequence, the lower your compounded rate of return will be.  In simple terms, don’t dig a deep hole you have to spend years climbing out of.  If you always swing for the fences, sometimes you’ll hit a home run but you’ll often strike out too.  Winning the long game is about small ball – singles and doubles.

Let’s take a closer look.  I’ve added another column to show the difference between the returns each year.  Highlighted in red is every year that the tactical strategy underperformed the Index.  What we can see is that the Russell 2000 Index was positive in every single one of those years and sometimes up a lot!  So it trailed during the big “up” years.

And here I flipped it.  Now highlighted in red is every year that the Russell 2000 Index was down.  You can see, highlighted in green, that the tactical strategy outperformed each of those years.  This is the key point.  To outperform over the long run, you can underperform during every “up” year as long as you outperform during every “down” year.  In essence, we’re pulling in the extremes.  We’re giving up some upside but that’s OK because we’re eliminating most of the downside.

This tactical allocation strategy is something I utilize within the Growth allocation of my client’s portfolios.  It’s applicable for any investor but I think it’s extremely effective for retirement focused investors that don’t have as much time to recover from big losses or the desire to experience them. 

Key Takeaways:

• Avoiding losses is way more important than maximizing gains or trying to “beat the market” during “up” years.  Turn off CNBC and ignore all the noise and FOMO.
• In order to outperform in the long run, you only need to outperform during years the market is down.
• Growing your wealth is accomplished through compounding of investment gains over time.  By focusing on managing risks (i.e. reducing the downside), less time is spent climbing out of holes and a portfolio will compound at a higher average rate.  I spend 5x as much time on analyzing potential risks as I do looking for new investment opportunities.  Gains take care of themselves; risks are the key.
• Stay patient, Rome wasn’t built in a day.  Compounding has an exponential effect over time.

Thanks for following!

-Nick

P.S. Some people may be thinking this isn’t realistic since trading costs and taxes will bring down the tactical strategy’s results (it’s net returns that matter after all).  But since you can buy and sell many ETF’s with no transaction charges at the big name brokerage companies, trading costs aren’t an issue.  Any tactical strategy that is more active will generate more taxable gains but as long you implement strategies like this in tax-deferred retirement accounts like IRA’s and Roth IRA’s then taxes aren’t a factor either and the two are on a level playing field.