If anything should have become clear these last few months it’s the critical importance of sound risk management.
It’s a lesson that tends to be forgotten by most investors at the tail-end of bubbles and re-learned the hard way when the bubble pops.
We forget this lesson after many years without a reminder and as everyone around us seems to be getting rich off skyrocketing asset prices. So, we chase performance without an understanding of risk or the extreme prices we’re paying for those assets.
In fact, about a year ago I shared a quote from J.P. Morgan that perfectly addresses this concept, “Nothing so undermines your financial judgement as the sight of your neighbor getting rich.”
I had a lot of people last year asking if we should be more aggressive, questioning if we were doing the right thing by being relatively conservative.
I consistently answered “yes” to that question because if we were relatively conservative there was a reason for it. Either (1) they didn’t have the financial capacity for the potential losses that could ensue meaning a certain level of losses would jeopardize their financial independence, and / or (2) they didn’t have the emotional capacity for the losses that could ensue, and / or (3) most risk assets were / are extremely overvalued (as I’ve written about many times).
Many of the trendiest assets that were being chased by retail investors (cryptocurrencies, meme stocks, overvalued tech stocks) are now down 70% or more from their all-time highs. Broad market indexes are down around 20% on the year.
Some people will respond, “But many of those assets are still up a lot from where they started years ago.” Unfortunately, that misses the point. The money invested in those speculative opportunities is relatively tiny early on. Bubbles suck money in near the top causing wealth to vanish when the bubble pops.
The prevalence of this boom-bust cycle throughout history is why I rely so heavily on time-tested economic principles…namely, that an asset’s price must ultimately reflect the long-term cash flows provided by the asset.
Almost all my clients have seen me draw my “guardrail” illustration (below). Excuse the crudeness, I did this on the computer with a mouse…
The blue line represents the stock market over time while the red lines represent the upper and lower guardrails. Every client’s guardrails may be set differently in that some are wider and others are narrower depending on their unique circumstances, goals and risk tolerance.
The general concept is that we will forego some returns in up markets so that we can also avoid the big drawdowns.
If we take care to avoid massive drawdowns and remain committed to our strategy in difficult times, the long-term returns will take care of themselves.
However, in order to do this we must resist the temptation to chase performance at the heights of euphoria and, conversely, resist the temptation to sell good assets at depressed prices in the depths of despair.
Now, if we had a very, very long time-horizon before we needed funds from our portfolios AND we had the emotional capacity to stay committed to our strategy even when our portfolios are down 50% or more then we would have no need for guardrails in the first place.
But, the fact is, most of us don’t have sufficiently long time horizons so a big drawdown at the wrong time can jeopardize our financial goals AND most people don’t have the stomach to stay committed and continue investing when their portfolios have been cut down to a fraction even if they can technically afford a big drawdown. Instead, most people end up stopping their portfolio contributions altogether or, worse, selling good assets at low prices, which can be extremely detrimental to long-term returns.
Therefore, risk management (guardrails) becomes necessary in order to provide the greatest probability of achieving out most important financial goals.