The upside of protecting downside

The trick in investing is not to lose money

That’s the most important thing. If you compound your money at 12% a year, you’re better off than investor who make 25% in one year and lose 20% next year, who have some great years and horrible losses in others. The losses will kill you. They ruin the compounding rate and compounding is the magic of investing.

Most investors give more attention on capturing upside while completely ignoring the importance of protecting downside. The bigger the investment loss, the greater the gain required to break even.

downside

As seen in the above graph a 30% loss will require 43% upside to cover it. And in many cases investors redeem their investment after losses and invest in much lesser risky asset which will take more time to generate such returns to cover earlier losses. Downside protection strategies can help free investors from their bad habits of overreacting to downside volatility and incorrectly timing the market.

Loosing less is gaining more

Investors feel that protecting downside means gaining less. No. It is actually gaining more. See in the below table. If markets are down by 20% and you protected 5% of this 20% fall, the gain needed to cover this is 18% instead of 25%. This means you gain 7% by protecting 5% downside. Likewise, when markets are down 50% and you protected 10% of this downfall, you actually gain 34%. This is the power for loosing less.

Loss

Gain needed to cover loss (A) Gain needed if you protect 5% downside (B) Gain by protecting downside (A-B)

-20%

25% 18%

7%

Loss Gain needed to cover loss (A) Gain needed if you protect 5% downside (B) Gain by protecting downside (A-B)

-30%

43% 33%

10%

Loss Gain needed to cover loss (A) Gain needed if you protect 10% downside (B) Gain by protecting downside (A-B)

-40%

66% 43%

23%

Loss Gain needed to cover loss (A) Gain needed if you protect 10% downside (B) Gain by protecting downside (A-B)

-50%

100% 66%

34%

High risk = high return is true for individual securities, but not for a portfolio. This is a common misconception among investors. Risk-Reward has a positive correlation, but it’s not perfect. Risky securities are diversifiable by lower-correlated or negative-correlated securities. By buying low-correlated securities to hedge your risky security, are you lowering your upside? No. You’re lowering your downside.

You can’t predict. You can Prepare

You don’t know when markets will fall so best way is to be prepared as if that fall comes tomorrow. I am penning down some easy ways to protect downside for your portfolio:

Targeting low volatility: In this strategy invest in low-volatile funds at first place. These strategies offer similar returns to equity market over long time with less downside risk. Funds such as Hybrid Equity Funds and Balanced Advantage Funds offer such low volatile returns.

Pros: Equity link returns in the long term. Tax efficient. 

Cons: Such portfolio will under-perform during extremes of bull market.

Diversification: Aims to smooth returns by diversifying the portfolio across equities, bonds, Gold and cash. Decide a fixed percentage in each asset class based on your risk profile and keep resetting it every 3 year to original weights.

Pros: Simplest and most cost-effective approach of limiting exposure to equity volatility. Traditional, well understood strategy.

Cons: Correlations between asset classes may change over time.

Active Asset Allocation: Asset-allocation mix is actively adjusted to match expectations about market conditions — allocating to less risky assets in higher-risk market regimes and more growth assets in safer times.

This is mostly difficult for a layman to do. Hence, I personally believe in 80:20 strategy. Invest 80% in equity and 20% in debt. Switch from debt to equity for every 5% market fall in a month. If markets don’t fall be patient, you are at least gaining on your 80%. If markets fall you will be happy as you will have money to invest more. Incremental investments should be adjusted in proportion so that you maintain 80:20 ratio most of the time.

Pros: Peaceful and easy to implement. No need to time the market.

Cons: Tends to lag equity returns in bull markets. Taxation. 

These are three simple ways you can protect downside. There are more difficult ways like option strategy and model based dynamic asset allocation which needs more active monitoring and expertise. But most investors will be better off following any of these three simple strategy. As they say, in investing simple is more powerful. 

Hope you understand the upside of protecting downside!

Happy Investing

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