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Are you too focused on Risk Reduction vs. Growth?

A few years ago, we held a client event that highlighted the difference between how different types of investors think. I had invited my favourite hedge fund manager and my favourite growth fund manager.

It was the contrast in their thinking that I found fascinating. The hedge fund manager was the true hedge fund type that tried to reduce risk and provide a mostly market-neutral, steady return. The growth fund manager was looking for index-beating long term out performance.

The hedge fund manager explained how minimizing losses and a “win by not losing” outlook can provide decent returns with a smoother ride. He showed a chart something like the one below to show how much of a gain you need to recover from a loss:

Loss Gain needed to recover Theoretical years to recover
10% 11% 1.1
20% 25% 2.3
30% 43% 3.8
40% 67% 5.4
50% 100% 7.3

Figure 1: Theoretical years to recover (10% compound annual RoR)

For example, if your investment falls by 30% from $100,000 to $70,000, you need a 43% gain to get the $70,000 back up to $100,000. Since the historical average stock market return is about 10% per year, it would take almost four “average” 10% years to recover. His point was that, if you can avoid or minimize losses, you can provide more consistent returns.

I noticed a few people in the audience nodding their heads in agreement with the low risk, comfortable message.

When he finished his talk, the growth fund manager rose and said: “What the last speaker said is absolutely true. The math is accurate. However, what he missed is that the stock markets do tend to recover. Large declines have historically been followed by large gains. The largest market crashes generally didn’t take any longer to recover than smaller ones.

He showed a table something like this. If you look at calendar years in the last 140 years, there have been 6 periods when there was a loss of more than 20%. Here they are in size order, followed by the recovery until the market was above its previous peak:

sp5001871-2012
Figure 2:  Historical Years to Recover after Largest Declines in History

He went on to point out that the years following large market crashes tend to have gains much higher than “average” 10% gains. The number of years to recover historically looked nothing like the theoretical years in chart 1. It is not a coincidence that the biggest bull market in history was from 1933-36, immediately after the largest bear market in history.

His main point was that the ups and downs are the cost of getting a higher long term return. Don’t fear the declines. The best returns usually are earned by investors that just stay confidently invested for the long term.

At this point, there was a murmur of insight from some in the audience.

After the presentations, I introduced the two fund managers to each other and, after some pleasantries, they continued their debate. The hedge fund guy pointed out that the chart showed periods of 6 or 8 years with no growth, during which his steadier fund would have made money. The growth manager countered that these are the 6 worst periods in 140 years. The 12 down years were less than 10% of the time. The other 90% of the time, the growth fund would have performed better most of the time.

I found it interesting that not only did the fund managers have different viewpoints, but most of the audience preferred one view or the other. I knew everyone in the audience, and could see that part of this was from the level of risk they were comfortable with, but part reflected their outlook on the world and on life.

Since that event, I have noticed these differing viewpoints in many fund managers. One is pessimistic and focused on avoiding losses first, while the other is optimistic and confident in long term growth.

I have also noticed that in different time periods, one or the other view becomes much more popular. During most of the 1990s, the optimistic, growth view was most popular with investors, while the pessimistic, defensive view has been more popular since 2008.

Which outlook speaks to you, and have you fully considered the implications for your investing success?

About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com.  You can read his other articles here.

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About the author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.

Ed has written numerous articles to educate the public and his clients on his unique insights into strategies that actually work, instead of the “conventional wisdom” common in the financial industry.

Ed has trained more than 200 financial advisors and is considered the Smith Manoeuvre expert in the Toronto area. He has received accolades from Frasier Smith in his book “The Smith Manoeuvre” for customizing this strategy for hundreds of clients. His extensive experience in tax and finance has placed him in high demand. Ed’s team collaborates on each of their clients to help them create financial security and freedom.

{ 24 comments… add one }
  • abraxas August 29, 2013, 11:46 am

    Something about that second table does not ring true. I thought that the 1929 crash would have you wait 25 years before you got back to even?

  • Simon Elstad August 29, 2013, 12:03 pm

    The growth outlook appeals the most to me. When I invest its for the long haul thus am not worried about the risks of the portfolio slumping at certain times. As you point out, most times slumps are followed by recoveries.

  • Al August 29, 2013, 12:30 pm

    Ed,

    I’m debating borrowing against my home equity to invest in equities however I’m self employed and 100% of my salary comes from dividends that are in a lower tax bracket so I can’t play the tax write off game as well as others. What do you suggest?

  • Goldberg August 29, 2013, 1:15 pm

    I agree with abraxas. Those numbers are bs.

    Dow Jones was at over 370 at its 1929 peak and was at less than 50 by 1932.

    It went from under 50 to almost 200 by 1937. Quadruple gains but who bought there really?!…. So by 1937, you were still 50% from the top…

    It wasn’t until 1955 that it went over 370. 23 years later.

    Ed, you can do better than all this misleading bs.

    In a court of law, everything you say would be thrown out. Zero credibility. Ed, you are supposed to be a professional yet you are less accurate with no fact checking than your average 15 year old blogger.

    S&P 500 started in 1957 and means nothing in 1929. Was there even 500 large companies listed in 1929? Templeton is famous for having bought all penny stocks in 1939… there was 104 of them… not 10’s of thousands like today.

  • fiscally fit August 29, 2013, 1:46 pm

    Always interesting info, but I have one issue with real life application of risk reduction…

    I could be crazy but it seems like very few people actually have a metric for risk in their own portfolio. Even less people measure it. People will say that they are adverse to a lot of risk so they do index investing or dividend investing or blah blah blah. In actuality they have no idea or at least don’t have metric to compare themselves to. Just an interesting observation haha but I could be crazy ;)

  • Paul August 29, 2013, 2:09 pm

    I am no expert but here is what I know. The crash in 2008 made me unhappy and nervous, but I sold nothing, and instead bought more shares of solid companies that I was sure were not going under, and I am happy that I did. It might have been different if I were planning to retire in 2008.

  • Ed Rempel August 29, 2013, 5:54 pm

    Hi Abraxas & Goldberg,

    The chart figures are completely accurate. They are the calendar year returns.

    It’s a common fallacy that the S&P took 25 years to come back from 1929. That is when you exclude dividends of about 5%/year, which is the figures you quoted, Goldberg. If you take the very peak day in 1929, it took until 1942 to recover.

    The chart here is calendar years. On December 31, 1936, the market was up from January 1, 1929. Taking calendar year returns, the 196% return in 1933-36 fully recovered the 63% decline in 1929-32.

    Finance scholars have US stock data back to 1802. There were, of course, a lot fewer stocks back then. The data includes all stocks traded on the New York stock exchange. There is more comprehensive data from 1871 and then again starting in 1926. The data I am using is the calendar year returns used by finance scholars from 1871. Here is a link if you want to confirm: http://www.moneychimp.com/features/market_cagr.htm .

    My point with this is that most people are surprised how quickly the stock market recovers from large declines. If you take the peak to trough months or days, it takes a bit longer than peak to trough years, but the point is still valid.

    The reason they recover is that the market is based on many large companies that can do many things to get their profits back up whenever their profits fall. If you’ve ever worked for a company, you would know what I mean. If their profits recover, the market eventually recovers as well.

    Ed

  • Ed Rempel August 29, 2013, 6:35 pm

    Hi Al,

    I know what you mean. My business is incorporated and I pay myself only dividends. My leverage interest is so high that I pay no personal tax (just corporate tax) and I have to juggle alternative minimum tax.

    The benefits of borrowing to invest are mainly from the long term compound growth of the investments vs. the interest cost. There are tax savings, but they are usually only a small part of the benefit.

    I would suggest to decide whether borrowing to invest is right for you based on the risk/return of the investments & loan, and on your risk tolerance and time horizon. I would suggest that you should have a time horizon of at least 20 years, so that you would have a very high chance of success. There will be some tax savings for you, as well, but the strategy can be a huge benefit long term even without tax savings.

    Ed

  • Ed Rempel August 29, 2013, 10:23 pm

    Hi Simon,

    Well said. I agree completely.

    Ed

  • Ed Rempel September 2, 2013, 1:16 pm

    Hi Paul,

    I guess you are in the middle. You tiptoed in at the bottom of the market. You did not sell, but you also did not confidently buy. It looks like you had moderate confidence in your investments and in the stock market, but you did add somewhat at the very low prices.

    Ed

  • Steve September 5, 2013, 10:24 am

    TSX peaked at nearly 15,000 then lost 50% from June 08 to March 09. Since then it has only spend about 6 months above 13,000.

    The ‘down years’ was about 1, but it’s still got lots more recovering to do from todays 12,750, and has realistically been fairly stagnant in the 12,000 to 12,500 range.

    And it’s fine to include dividends as part of the return numbers but make sure you’re doing real returns. During the 30s, with deflation the ‘returns’ are actually better than the math says. But the 40s and 50s where inflation was much higher, your dividends don’t suddenly turn you into a winner, they were most eliminated by inflation.

    Real return charts!

  • Hunain @ HowToSaveMoney.ca September 12, 2013, 6:33 pm

    Thanks for explaining how to calculate the return. I think in the long run we should more focus on risk reduction because if we work on that the slow growth will automatically come without many setbacks.

  • SST September 13, 2013, 10:28 pm

    Now that I’ve regained my fulmination from an extended vacay in Hawai’i…down to business.

    re:
    #4 Goldberg: “Ed, you can do better than all this misleading bs.”
    #7 Ed Rempel: “It’s a common fallacy…”

    I agree, pre-index fund information is a total fallacy pushed ever so diligently by those in the financial industry (as contributing “professionals” have demonstrated endlessly), spearheaded by the High Lord Siegel who utilizes distorted data, and wrongly to boot.
    “Misleading bs” indeed.

    Thing is, all that “US stock data back to 1802” garbage is completely theoretical, meaning it is completely useless in any application to real-time investing, either now or historical. As has been said: In theory, there is no difference between theory and practice. But, in practice, there is. Even billionaire Charlie Munger has said “There wasn’t enough common stock investment for the ordinary person in 1880 to put in your eye.”

    No one has ever owned every single issue of the S&P and thus being eligible for the “dividends of about 5%/year” — no one. Besides that, between the disputed years of 1929 and 1936, there were many additions and substitutions, as well as complete failures to zero, which would mean an investor would have to pump even more money into the complete index in order to reap full dividends.

    In 1927 the S&P Index (Daily) held 90 issues, rising to, obviously, 500 stocks in 1957. Could you imagine being an investor in 1960 and having to buy 500 individual stocks!?! LOL to that financial pillar of a joke.

    Many, many intelligent people have eschewed Siegel’s “bible”, ‘Stocks for the Long Run’, dismissing it as hogwash (one of the best being, again, Mr. Billionaire Munger — co-pilot of Bershire-Hathaway — calling Siegel “demented” and “a nut case”). I would advise any reader to do the same.

    Of course you could always follow more Siegel sage-ism and just buy into all 500 components — period. No more buying or selling, just hold. You would be on target for greater-than-index gains through M&A, spin-offs, etc. What a Wonderful Wharton World it Would Be!

    The ONLY points worth any validation (from the previously commented example) are the nominal highs and lows (and vice versa):
    01/1929 – 12/1936 = -31%
    01/1929 – 12/1952 = +4.5%

    (As a note of interest, household stock ownership stood at 90% in 1952, falling to a current 52%. Extrapolate your own conclusion.)

    It took almost 25 years for the S&P index to show a positive gain. But that in itself is merely another financial theory aka ‘reality fallacy’. Even if an average investor held his portfolio for this quarter-century period, whose to say he would receive the same same returns? All the companies in said portfolio could have gone bankrupt, even if not, whose to say that any number of the many thousands of failed banks and brokers did not take said investor (and/or non-investor) down with them?

    No financial industry professional will ever tell you any of this. Your knowledge of reality does not benefit their wallet. The pre-1970’s data is nothing more than voodoo economics. But, hey, the ruling powers of the day all demanded the Earth was flat and screamed as much to the general public for hundreds of years. Good thing everyone believed them.

    re: #5 fiscally fit: “I could be crazy but it seems like very few people actually have a metric for risk in their own portfolio. Even less people measure it.”

    Could you please present the mathematical model you use to measure risk in your own portfolio? Please include all metrics with which you measure or calculate such things as government-abeted institutional fraud (LIBOR, MBS), government-led financial rule changes (Halloween Massacre, SEC volatility limits, Alphabet props), mechanism failures (NASDAQ SIP), market manipulations (SAC, THI), etc. etc. Thanks.

  • Fiscally fit September 13, 2013, 11:01 pm

    @ sst

    Welcome back but wtf are you talking about?

  • SST September 14, 2013, 12:14 am

    Talking about your personal “metric for risk” and the measurement of it.
    What is your definition of investment risk and how do you measure it?
    And if your brackets of risk and measurement contain none of the items on my list, why or why not?
    Thanks.

  • thefiscallyfit September 14, 2013, 3:34 am

    @sst now I understand, bear with me as I am using a phone haha. The following is in no particular order ;)

    For my portfolio I calculate the usual stats like beta, alpha, std dev, sharpe ration, r squared, etc. as a basic measure to benchmark myself as a PM for my own funds.
    I then use some computational finance methods to measure a few other figures just to get some non biased info (see Cornelious Los’ work if you want a light read lol had him as a professor in university. Lots of theories but some legitimate ways to “unbias” bias financial information)).
    I do the usual filters with valuations on individual securities or funds to make sure they still fit my risk profile. I also regularly review the other standard stuff like am I “diversified enough” I am taking advantage of private equity or purchasing more businesses. I also make sure I document the time I spend doing this type of stuff as my time is valuable and needs to be factored in haha otherwise I risk the doghouse with the wife lol The non systemic and systemic risk items you mentioned are always the outliers (although they happen more and more often) that I try to build in margins of error for.

    Not one thing works by itself but together it gives me at least a basic snapshot of how I am performing as my own PM and if I am managing things efficiently… regardless of asset or asset class. The big things are that I am always evolving my metrics and that I am even documenting anything at all. Sorry for the butchered response but typing on an iphone is a pain in the arse haha

  • SST September 15, 2013, 12:39 pm

    re: #16 — 1. “For my portfolio I calculate the usual stats like beta, alpha, std dev, sharpe ration, r squared, etc….I do the usual filters with valuations on individual securities or funds to make sure they still fit my risk profile.”

    2. “The non systemic and systemic risk items you mentioned are always the outliers (although they happen more and more often) that I try to build in margins of error for.”

    Sounds like you have a lot of bases covered. I will ask why you don’t put more risk analysis emphasis on “the outliers” as it those which effectively make the market. They are not outliers if they permeate and dictate the market.

    Your evaluations of “individual securities or funds” is great but you have to know by now that you are not actually buying the underlying company — you are buying into the market place.

    Eg. there is a 180-degree difference between you buying Nokia stock and thinking you are buying the company, and Bill Gates actually buying Nokia the company.

    Eg. Suncor was pumping oil when oil was $140pb; their stock (SU) was valued at $70. Suncor was pumping oil when oil plummeted to $30pb; the stock fell to $20. No difference in the behaviour of the underlying company, -70% difference in the behaviour of the stock.
    Last time oil was at $100, SU was at $50; what is now undervalued, the stock or the company?

    Eg. Buffett dumps $500 million into SU stock, the stock rises 10% two months later when the information is made public. Did company risk all of a sudden decrease? Why did the stock not rise upon initial purchase instead of upon public report?

    Even though not everyone died, it would have been nice to know about that iceberg. ;)

  • Derek @ MoneyAhoy.com September 20, 2013, 5:02 pm

    Agree with #1 and #4 – I’ve always heard that we didn’t return to the 1929 high until after WW2. Maybe that wasn’t factoring in reinvesting the dividends?!?

  • SST September 21, 2013, 3:18 pm

    @Derek: read #13 for the answer to your “reinvesting the dividends” question.

  • Ed Rempel October 14, 2013, 1:40 pm

    Hi Derek (#18). Anybody that says the stock market did not recover from 1929 until after WWII is omitting the dividends. They use the price only index, which excludes the payment of dividends. Not just the reinvestment of the dividends but the payment of the dividends. It assumes you owned the stocks in the index but did not include the dividends you received.

    At that time, the average dividend payout was higher than today – it was about 5%. So those charts are missing 5%/year of the stock market return.

    You always need to be careful with stock market indexes as to whether you are looking at the base index (price only) or the total return index (which includes the dividends).

    Ed

  • SST October 14, 2013, 3:38 pm

    Please provide a real life instance of i) a dividend-paying stock portfolio and/or ii) a portfolio which contained ALL issues of either S&P index (90 or 233) from 1929-1950+.

    *NOT* a theoretical model, but an actual and true portfolio held by the average household. Heck, I’ll even accept the real stock portfolio held by the wealthy of the day.

    Thanks!

  • SST October 16, 2013, 11:13 am

    The Prime example of the power of investing in Private Equity vs. public equity:

    In 1902, the Dodge Bros. invested $10,000 in the Ford Co.

    By 1919, they had exited all Ford positions with gross returns of $55 million — a 550,000% return (as well as building their own $200 million auto company with Ford dividends).

    The Ford Co. didn’t go public until 1956.

    If you bought $10,000 (inflation adjusted) worth of Ford IPO, today, almost 60 years later, your initial investment would have returned ~$3 million (DRIP et al) or ~9,600%.
    [note: dirty calculations, please feel free to correct]

    Pitting equal amounts invested, the Private Equity investment returned over 540,000% more than the public equity investment, and in 1/3rd the time.

    The Dodge deal is considered the most profitable investment deal in US history.

    A perfect example of how important it is for your money to be as close as possible to the center of profit.

  • Harry October 23, 2013, 3:33 pm

    I agree with what the mutual fund manager said to an extent because usually whenever we have seen a large decline in the stock markets, especially during times of recession, with investors’ wealth plunging and severe notional losses being seen, the market has tended to recover equally quickly in the following years. However one cannot make an outright declaration based on this alone, so one has to be careful about keeping the right balance between risk and growth.

  • Ed Rempel July 26, 2015, 4:03 pm

    Hi Harry,

    I agree. Keep a balance between risk & growth.

    Incidentally, the market has historically been consistent in recovering from bear markets. Other than the 1929-32 crash, when there has been calendar year with a loss of more than 20%, the very next year has always been a gain of more than 20% (S&P since 1871).

    It pays off to be confident in your investments and to think long term.

    Ed

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