Importance of Risk Management
“It’s not what you make, it's what you keep that counts!"
Risk management is of great interest to investors; particularly in light of the 2000-2002 and 2008 bear markets and year-by-year stock market gyrations. We employ an ongoing, multiple element risk management process. We also rely on common sense and the judgment of professionals that is based on decades of market experience. We analyze the amount of risk we are taking on behalf of shareholders, both on an absolute basis and relative to benchmarks. We use this data to help us determine how to best position the fund, in light of current/ongoing market conditions and other variables.
The Fund is managed in such a way that the Fund’s shareholders may be able to avoid the devastating impact that can occur with various money management strategies that fail to appreciate the role risk reduction plays in potentially achieving attractive long term returns.
By assessing where opportunities vs. risks are unusually compelling, via our ConVal® investment approach, we can proactively adjust the funds asset allocation via both the stock/bond mix and individual holdings.
Impact of Steep Losses On Investor Returns
Numerous studies have demonstrated that:
Lessening the extent to which an investment portfolio suffers
Significant negative returns over a given period of time.
As an example, to make up for a negative return over the prior 12 months of -50%, the investment would need to rise 100% just to get back to break even-not a very likely scenario.
The steeper the losses, the higher the degree of difficulty of ever catching up.
During the bear markets of 2000-2002 and the fall of 2008; the S&P 500 index dropped a cumulative total of approximately -48%. In dollars, $100,000 dropped to $52,000. Many investors falsely believed that to get back to where they started, they needed to earn 48% to get back the lost $48,000. While this may seem logical to some, the math doesn’t work that way. In order to move from $52,000 back to $100,000, the investor would need a return of 92%, that’s right 92%! They would need to average 6.76% per year, over ten years to get back to where they started.
The NASDAQ index suffered a devastating 72% loss during the tech bubble bursting between 2000-2002. Here an investor’s $100,000 dropped to $28,000. In this case, a 257% return is needed to get back to $100,000. This investor would need to average 13.58% over ten years.
Steep losses in the stock market this decade have impacted millions of pre-retirees and retirees, with many having to delay retirement and/or go back to work. Some will not live long enough to see their wealth recover. Some can now be found as greeters in their retirement years at Wal-Mart or Home Depot, trying to stay afloat after their savings were swept away by the "poor decision making, poor advice" hurricane.
Many of these folks’ savings were devastated by either poor advice and/or attempting to “self direct” their wealth. Too many investors bought into the “new economy, this time it’s a different story”.
The High Degree Of Difficulty of Rebuilding Wealth After Steep Losses
The chart below illustrates the concepts we are sharing in our commentary above.
Severity of Negative Return Wreaks Havoc on True Performance
Consider the examples in the following table:
|Negative Return||Return Required To Make Up Prior Year’s Negative Return||Comments|
|-10%||11.1%||Still no problem|
|-25%||33.3%||This can be made up|
|-70%||233.3%||Where is Dr. Kerxxxxxx?|
We call this the “volatility penalty”
Deeper negative returns in any given year penalizes the investor due to the fact that the more negative any single year’s return is requires that the subsequent year not only have a positive return equal to the negative return, but also be more positive due to the fact that we are working from a lower account value created by the negative return. This is why when investors look at hypothetical return charts for the stock market and see that the S&P 500 has returned an average of 10+% per year annually since the 1920’s they get sold a bill of goods that having more money invested in stocks is the way to go.
The Wade Tactical L/S Fund Seeks
To Protect Against Severe Market Declines
The Wade Tactical L/S Fund does not necessarily seek to outperform stock funds when the market is doing well, but strives to protect against significant losses in order to provide competitive long-term returns without taking excessive “down year” risk.
What follows is a hypothetical example of the impact that wide swings in year-to-year performance can have on the accumulation of wealth.This information is for educational purposes only and is not a promise, prediction or guarantee of the performance of the Wade Tactical L/S Fund.
Hypothetical Example: ABC Fund
An investor in the “ABC” fund starts out with $100,000 and experiences hypothetical returns over the next five years of: +23%, +22%, -9%, 11%, and -17%.
- The “simple average” annual return for the investor, without compounding equals +6.0%.
- A hypothetical ending balance at 6% per year would equal $133,822 after five years. Unfortunately, this is not what the investor ends up with.
- The cumulative compounding of negative and positive yearly returns results in the investor capturing 78% (+4.7%) of the “simple” method calculation result of +6%.
- The true value the investor ends up with equals $125,808 after five years, not $133,822.
Hypothetical Example: XYZ Fund
An investor in the XYZ fund starts out with $100,000 and experiences hypothetical returns over the next five years of: 17%, 15%, -2%, 6% and -6%.
- The “simple average” (take the annual return of each year, then total and divide by five) annual return for the investor, without compounding equals +6.0%.
- The “average compound” annual return for this example is +5.6%, not 6%.
- The hypothetical ending balance would equal $131,384 at the end of five years.
- In this example, the hypothetical “XYZ fund investor captured 92% of the “simple” method calculation vs. 78% in the previous “ABC” fund example.
The chart below illustrates the concepts presented in our commentary above.
|Hypothetical Performance||Original Invest.||Year 1||Year 2||Year 3||Year 4||Year 5||Simple Avg. Return||Comp. Annual Return||Return||Value|
|ABC Stock Fund||$100,000||23%||22%||-9%||11%||-17%||6.0%||4.7%||25.8%||$125,808|
Why the difference?
The “simple” method of adding each year’s return together, then dividing by five is 100% inaccurate. The simple method can only work if each year’s return is identical.
The method of calculation that is required is called “internal rate of return” (IRR). Calculating each year’s return individually, by compounding each year’s ending dollar value, is the accurate way to measure the investor’s true average return on their investment over the five years.
The key to successful long term investing is
avoiding severe negative returns that will
take too long to make up.
Cycle of Investor Emotions
While it should be textbook strategy for investors to be willing to “buy low” and “sell high”, thousands of years of “human behavior wiring” make this impossible to implement for most investors. Numerous studies of investor behavior indicate that achieving solid long-term investment results are disabled by “greed and fear” for the majority of investors.
Too many investors prefer to buy “when the news is good” and sell “when the news is bad. The Wade Tactical L/S Fund allows investors to delegate the emotional aspect of achieving successful long-term investment results, allowing the Advisor to navigate the choppy waters of market psychology.
The chart below features how the “investor’s brain” works.
The way the stock market works is, that for every seller, there has to be a buyer. At times of financial crisis, when the stock market is way down, and the news media is telling you that the Great Depression 2 is coming, a redistribution of wealth takes place:
- Scared, “media-informed”, confused, impatient and panicking investors greatly outnumber the number of buyers. It is these limited number of shrewd buyers (like Warren Buffet and we believe WFG) that do the noble thing, they buy, buy and buy, allowing the sellers to “feel better” that they are doing what their gut is telling them to do.
- Panic selling is not limited to individuals. Investment committees of pension plans, endowments, etc. are also notorious for “chasing” the stock market, both on the way up and on the way down.
We desire the shareholders of the Wade Tactical L/S Fund to be on the winning side of the wealth transfers that take place when emotional investors are willing to “give away” investments worth much more than they perceive, so that they can feel better short term.
Industry Studies of Investor Behavior (1)
To further complicate the “forces” that investors are up against, the field of behavioral finance has shown that regardless of how investors may fill out various risk questionnaires (with results often suggesting that based upon a greater than 10 year time horizon they should allocate 75-100% to stocks), investors are in reality “risk averse” and do not react equally to gains and losses.
It is one thing for an investor to attempt to forecast their emotional reaction in advance of a bear market. It is completely another to experience the negative returns and reduction of wealth based upon actually participating in a bear market. In fact, research by Kahneman and Tversky, among others, has shown that:
- Investors feel the pain of negative returns 2-3 times stronger than they feel the joy of positive returns.
- Regardless of the long-term return potential of an investment, many investors simply cannot emotionally tolerate the volatile price swings of portfolios with a high allocation (75% or greater) to stocks.
The managers of the Wade Tactical L/S Fund believe that investor’s should steer clear of trying to hit home runs with the high incidence of striking out and instead focus on the more emotionally positive path of building wealth the old fashioned way: slowly and surely, with an eye towards risk management being more important than focusing on “big returns”.
Studies by the Bogle Financial Markets Research Center on investor behavior also indicate that most investors (self directed or professionally advised) capture less than 50% of the actual return of the stock mutual funds they are invested in over time. This is a result of a consistent cycle of "buying high and selling low". We call this “shooting yourself in the foot with the same gun repeatedly” behavior.
The chart below provides a hypothetical example of the devastating results on wealth accumulation negative investor behavior can play:
|Comparison||Starting Capital||Average Return||Ending Capital In 10 Years||Income From Ending Capital @5% Withdrawal Rate||Percentage of Potential Income Captured|
|The Hypothetical Return Offered By The Stock Market Via “XYZ” Equity Mutual Fund||$100,000||10%||$259,374||$12,969||100%|
|Hypothetical Returns Experienced By Investors Who Buy High and Sell Low In The “XYZ” Equity Mutual Fund||$100,000||4.5%||$155,297||$7,765||60%|
The Wade Tactical L/S Fund removes the emotions of investing typically experienced by investors via our ConVal® (contrarian value) investment approach. Instead of the investor succumbing to their emotions of letting the news media and/or investment and insurance pitchmen place them on what history has generally proven to be a poor future cumulative outcome concerning their wealth, the Wade Tactical L/S Fund lets an experienced fund management team to “do the driving”, significantly improving the chances of an investor’s hard earned dollars earning a reasonable, compound rate of return over time. The Fund is driven by a process that attempts to limit the severity of negative stock market returns when they occur, yet providing for the capture of an important portion of positive stock market returns as well.