“Invert, always invert”
"Man muss immer umkehren" (loosely translated as “invert, always invert.”) was a favored problem-solving approach for mathematician Carl Jacobi. It has proven to be good advice for thorough investigations of various topics. We'll apply it today to the concept of investing risk management.
We usually think of risk as the possibility of something bad happening. As an investor this could be the possibility of losing money. Let's invert and consider risk as the possibility of something good not happening. For an investor this could be the risk of not getting a return, or not getting enough return.
Investor A has a $100,000 portfolio but is worried about a recession and the continuation of a bear market (downside risk) so sells half of portfolio.
Investor B also has a $100,000 portfolio but is mainly worried about missing the next bull market (upside risk) so continues to hold her portfolio in full.
If the bear market continues (say for another loss of 25%), Investor A feels smart. He's guessed correctly. His portfolio has only declined to $87,500. Investor B has lost the full 25% to $75,000.
If the market then goes into a bull market (let's say it doubles as would be typical), Investor A waits until he is "back up again" to become fully invested. He catches half of the bull market and his portfolio increases to $131,250. Investor B stays invested. She ends the bull market with a $150,000 portfolio.
Investor A reduced his downside risk by $12,500 in the bear market. He also did not receive $18,750 of the upside that Investor B received.
This scenario is common. The $18,750 is real money. Investor A never gets it and can never spend it. Upside risk is as real as downside risk although it is often "out of sight, out of mind".
In real-time, bear markets are quite scary. In hindsight, they look like little blips on the price chart (see last month's letter). Ben Carlson quoted a response to his A Wealth of Common Sense blog post from an investor who actually experienced the 1987 crash, with his life savings on the line:
As one who was actually invested in 1987 (and since 1973), I still have vivid memories of that market crash. It is oh-so-easy to look today at a long-term chart having a tiny blip and say “So what! . . . of course the market recovered . . . those who sold were fools.”
In 1987, market news was nothing like it is today. We had no Internet. We had the next day’s WSJ and Friday’s 30-minute Lou Rukeyser’s Wall Street Week; we subscribed to a few stock newsletters (delivered by snail mail) and Kiplinger and Money magazines . . . that’s about it.
Therefore, though I heard about the crash on the radio as I drove home from work on Black Monday, I was not prepared to find my wife in tears . . . her first words were “You’ve lost our retirement!” (Reading it does not convey the impact of hearing it.)
In real time, the crash was a VERY big event. Fear for a changed future was the natural response. Talking heads were saying “This worldwide event could last for years; our children will have a lower standard of living than we have.”
Long story short— she insisted we sell everything the next day (which was also a significant down day); we eventually re-entered the market.
We modern investors feel the same naturally negative emotions investors always have during bear markets. It is the price we pay for maintaining our future upside!
References:
https://awealthofcommonsense.com/2017/10/what-the-charts-dont-tell-you/
https://www.hussmanfunds.com/comment/mc221016/
finance.yahoo.com
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