No matter which team you were rooting for, we were all reminded recently that, “The best offense is a good defense.” I don’t know who said that first, but the Denver Broncos demonstrated it as well as anyone in the 2016 Super Bowl. My point, of course, is that offense is never enough.
You need both offense and defense in any game or business, and the same applies to investing. As you know, with American football there are two basic teams of 11 players each. The Super Bowl is considered a de facto national holiday where we spend most of the day, and a lot of money, watching the 11 man offense attempt to advance down the field by running with or passing the ball, as the 11 man defense aims to stop their advance and take control of the ball themselves.
As you read this, wear your favorite team sport hat and think like a team owner. Notice how team owners fill in the blanks with names of those players who play on offense and those players who play defense. Even in the land of Spend, baby, spend! It is astonishing that NFL Commissioner, Robert Goodell made $34.1 million in compensation in 2014, according to ESPN on February 17, 2016.
As team owners and investors, let’s look at the real cost of volatility. Most investors know what positions or players you own that can help you make money in a good market. Unfortunately many investors are not able to identify any positions they own that may help them limit their losses in bad markets so that they can stay in the game. Please answer this question. What can you possibly own in your portfolio that may help you win by losing less?
This is math you can do. When asked the question, hypothetically, if your account had a -20% loss, what do you need to get back to even, most investors answer 20%. As you can see, that gain would leave you short of your initial investment. To completely recover your losses, you need a 25% return. Just go back to 2007-08 to see what you might have done to limit your losses to -20% or less. This way you may be better prepared for the good, the bad, and the unforeseen in 2016.
This is where the situation becomes even more interesting, if not severe. We have all learned the mantra “buy and hold.” That may work when there is no need for withdrawal income. If your investment account experienced a loss of -40%, with no withdrawals, you need a gain of 67% to get back to even. If, however, you had set up a withdrawal speed limit of 5% a year, you will need a cumulative gain of 115% to get back to even! To achieve such results means the annualized returns would need to be 16.59% a year.
I don’t know about you, but I don’t like those odds.
Under the same scenario, if the loss was -20%, with the same 5% annual withdrawal rate, you will need a cumulative gain of 62% or an annualized return of 10.07% to get back to even. Now you can stay in the game. You may even enjoy it.
On February 8, 2016, Harry Dent wrote to subscribers, “Many years ago, I went back through the last winter season focusing primarily on the 1930s – the worst crash and depression in U.S. history. I was thinking there must have been some stock sector that did well. Utilities, phone companies, booze, cigarettes, gambling, consumers staples, something! But no – all of those sectors fell. Some stocks fell worse than others, namely automobiles, but not a single one escaped the carnage that ensued..."
And even for the most stable companies, it wasn’t because their sales and earnings fell. Rather, it was the fall in their price-to-earnings (P/E) ratio. When fear sets in, investors price in the worst scenario for everything. Even when adjusted for dividends, stocks suffered a 20% loss for the decade. At their worst in July of 1932, they were down 89%! Real estate bubbled less and so fell less, but still had a slightly negative return for the decade. And commodities… forget about it! But this is where a good defense would have helped. The one sector that did well (with minor volatility to boot) were the highest-quality, long-term bonds… which is about as defensive as it gets! Look at the chart:
Long-term Treasury bonds nearly doubled counting their yields, and AAA corporates more than doubled in the worst decade for stocks and the economy ever. How’s that for a strong defense?”
So my suggestion to you is this: be like Denver. This is not the time to rely solely on offense. Now is the time to bring out your best defense and prepare for another volatile year. If your investments were off -50% two times between 2001 and 2010, ask your financial advisor what can you learn and apply today to be better prepared for the next time the grits hit the pan.
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