The markets have been pretty uneventful today and quite frankly boring. So on day where the market is pulling back and taking back some past gains, I thought this might be the perfect opportunity to remind readers again why capital preservation is every bit as important as capital growth.
As an example, did you know that for every ten dollar you lose in the markets, it takes eleven dollar and ten cents to get back that original ten dollars? This ratio only grows as your losses increase. What is particularly surprising to some is that it takes a 100% gain to recover a 50% loss…see below.
Market Loss = -10%
Required Recovery = +11.1%
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Market Loss = -25%
Required Recovery = +33.3%
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Market Loss = -50%
Required Recovery = +100%
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So don’t let someone pull the wool over your eyes and make you believe a 50% loss in one year, followed by an equal gain in the next is break-even. It is not!
This is why it’s so important to preserve capital. This is also why we sometimes may seem slow to increase exposure on a market move as we want the market to prove itself.
Most recently the range bound trading in the markets has created real headaches for investors (including us) as it is just too much trading for most accounts to be constantly flipping from fully long to all cash or short. Additionally, there has been no shortage of false signals to confuse managers.
This is exactly the kind of market environment that requires real and robust risk management processes? We use a number of tools to do so including:
- Proper diversification of positions
- Limiting exposure to any one position
- Examining the correlation of positions or investments
- Limiting losses size through the use of stop loss orders or mental stops
- Setting target prices for positions
- Using portfolio hedging techniques in difficult markets
Its funny, the latter technique always seems to draw the most reaction from our clients as it is sometimes seems strange to them. We are constantly questioned on why we use a short or inverse position in a portfolio that is primarily long. This question may seem strange to you as well, but the simple answer is we are hedging to limit overall portfolio exposure to the market to a certain percentage of total capital.
If our process has us worried about further market advances relative to the risk to capture those advances, we may increase the hedge position. Alternatively, as we become more comfortable we remove or reduce such hedges to increase our exposure to the market and potential for participation in its moves.
The use of hedge in a very volatile market is often much simpler that constantly buying and/or selling positions based on the range bound fluctuations of the market. With the ease at which investors can hedge today, we think it makes a lot of sense in these constantly changing markets.
