Let us start by reviewing the main cost that all investors are attempting to reduce – the cost of bad timing and doing the worst thing at the wrong time. The cost of this emotional reaction to downturns has been shown to average 2% per year or a quarter of the average annual return seen by the investment markets. The focus of all downside protection strategies is to lessen this cost.
One of the first approaches used was to blend fixed-income instruments with equities. Fixed income has traditionally provided less volatility and downside then equities. However, there is an offset to that benefit – a lower expected return. When blended with equities, it is true fixed income dampens downturns, but it also dampens upturns, eliminating the opportunity to get the market’s full potential.
In the 1980’s, the idea of stop losses – also known as portfolio insurance – was introduced. Stop loss strategies have gained acceptance, yet they have several shortfalls. Stop loss strategies look for a change in momentum. This approach is susceptible to false sell signals in volatile markets, as well as, in trendless markets. Also, getting out is only part of the solution. When to re-enter is a far more critical decision. Studies show stop loss strategies have been unable to produce optimal returns throughout the investment cycle.
In the 1990’s, the concept of using derivatives for protection gathered acceptance. However, the cost to protect downside can be expensive. No matter the option strategy, the option premium required to implement quickly eats the market’s upside potential. And if you wait to add protection only when you think you need it, the increased expense will dampen returns further.
In the mid-2000’s, a new approach utilized volatility-adjusted momentum. Like many before, it suffers from the limitations of following one signal. Though a historically strong signal, momentum is also known for being volatile and having fallen the most during the most severe downturns. Not what you want when you are looking to protect against the downside. Similar to the stop-loss strategies mentioned earlier, this approach is reactive, feeling the loss before it starts to protect.
Innovation since the 2008 collapse has resulted in a new invest philosophy – Regime Based Investing. It looks to adjust asset allocations based on the investment phase or regime expected. It recognizes that many signals need to be monitored to understand the changing environment. By broadening the signal base, it offers a gradual approach, reducing the chances of false sell signals. And it has the potential to mitigate losses without giving up the market’s potential.