Mark Hulbert's latest column for Marketwatch takes a look at work done by Brian Livingston that near and dear to my investing heart believes that it is far more important to worry about the size of your decline in bear markets than whether or not you outperform your benchmark during bull markets.
The article seems to focus on the idea that a 50% decline needs a 100% gain to get back to even but that the worst performing newsletter that Hulbert follows dropped 79% during the crisis and so still isn't back to even. While there is no disputing the numbers, that isn't the most compelling component for why I focus so much on protecting against the downside.
There are two reasons why I find it so important along with one positive byproduct of this approach. The first thing is that the longest term, most rational investors quickly and easily lose sight of their time horizon and give up on what they know is rational in the face of large declines. Someone who is 40 or 45 today could easily see two-four more this one is different declines before they need their money for retirement. Someone that age in 2008 or even 50 or 55 in 2008 had no reason to sell in the context of their time horizon but of course we know that many investors did panic out. Selling after a large decline and then watching the market rocket higher without you is about the worst thing that an investor can do. While no one thinks they will do that, some inevitably do just that. Watching it drop and doing nothing is the far better outcome because once the market is done declining, it will go on to a new high. The only variable is how long it will take. This is rational but very difficult to believe after a large decline. If you don't believe that as we sit here today near a high, you should sell right now.
The other crucial point of trying to avoid the full brunt of large declines is the very practical matter of retirees/clients taking portfolio withdrawals in building their income. A 60/40 equities/fixed income portfolio will drop 30% if the S&P 500 cuts in half (assumes index-matching returns). Either a retiree takes the same amount out of their portfolio which is risky because that same withdrawal amount will be a larger percentage of their portfolio which may not be sustainable or they will take less out which risks coming up short versus their expenses. Using simple math, if someone only takes on half of the bear market decline then those two risks are obviously lessened considerably.
The positive byproduct of actively and aggressively trying to mitigate the downside is that if you can do it, you'll be adding a lot of alpha (outperformance) in the short run that can last for many years in terms of helping your average long term returns. Sticking with the example above, a 25% decline when the market drops 50% could be thought of as giving 2.5% of alpha every year for ten years.
For anyone managing their own portfolio, you need to focus more on saving as much as you can, never panic selling (or other behavioral mistakes) and just being fairly close to the market's return and even then being close to the market may not be crucial. People who can be happy living below their means don't need to spend as much time worrying about returns (something they can't control) versus their saving and spending (things they can control).
Getting to that point can make every aspect of your life easier which is a point I make in my book Random Roger's Rules: Building Blocks For A Happier Life which I hope you'll consider purchasing. Half of the my net proceeds will be donated to Walker Fire.