Are You Too Focused on Risk Reduction Instead of 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:

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:

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?