Downside Risk and Big Ifs

It has been a while since I reached out through these emails, but I found something which inspired me to write again.

In January, I read this article on a disastrous NFL bet. The Los Angeles Chargers were up 27-0 on the Jacksonville Jaguars as the first half ended. With a Chargers win seemingly assured, one investor decided to place a US$1,400,000 on their victory.

The Jaguars mounted a Viking comeback, winning 31-30.

At the end of the first half, the odds of a win for Jacksonville were low. So low, that our unlucky gambler only looked to gain $11,200, 0.8% of their bet. They probably thought this was an easy 11 grand.

In the investment world, accepting a very unlikely risk with a potentially cataclysmic outcome is often referred to as "picking up quarters in front of a steamroller".

This term was famously used to describe Long-Term Capital Management, also known as LTCM. Their strategy was highly leveraged and involved frequently trading bonds, making small gains on each trade. The risks of something happening in bond markets was small, but due to the amount of debt used, a black swan event could spell disaster for the gargantuan $5B fund.

The event came, with the Russian government defaulting on it's debt. The collapse of LTCM's fund was so severe, the US government feared it could spark a financial crisis, stepping in with a $3.65B to bailout the company.

This kind of downside risk, where the odds are low but outcomes severe, are not unique to investing and gambling. This risks are the reason insurance exists. The recent flooding illustrates this well, where a 1 in a 100-year event  (possibly a 1 in a 1000-year) caused wide-spread destruction. Insurance exists for these events, which are unlikely yet potentially devastating.

Unfortunately for investors, most investments don't have insurance, so how can we manage these risks?

Holding a share in a single company, or even a portfolio of a dozen shares, introduces a considerable downside risk. Even well established companies can fail (think of Enron, Bear Stearns, Lehman Brothers, and more recently FTX). When they do, that could represent a large part of an undiversified portfolio.

Less risky investments, such as bonds and term deposits, still carry these risks if not diversified. A company with a AAA credit rating has a 1 in 600 chance of default over 5 years. The odds of losing capital with a bond from such a company is low, but why accept that risk?

Diversification minimises the effects of any given company failing. The portfolios we build for clients have more than 8,000 holdings. Although some of the companies we invest in may fail, the impact is negligible and will be offset by other companies performing well.

We often say, if you have 10 cows and one doesn't return in the evening, you would notice. If you had 8,000 cows, I don't think you would be stressing.

Inexperienced investors often believe including shares in their portfolios introduces the risk of "losing money". By diversifying, this is no longer a concern. The true risk of investing in shares is idiosyncratic risk, which cannot be diversified away. Some market events will affect all the shares in your portfolio. When accepted, it is this risk for which investors expect to be rewarded.

The impact of the sports bet mentioned above is clear. If it doesn't pay off, the gambler loses their money. The same goes for LTCM's high risk strategy or buying a single share or bond.

The impact of a market event is temporary. We know markets always recover. The risk is your portfolio may fluctuate in value considerably, often at inopportune times. We manage this risk by choosing the right mix of investments for the investor and taking a long-term approach.

Can we learn anything from the examples above? First I would say that the impossible can happen. When it does, you do not want to be on the wrong side of a big bet. Secondly, through diversification we can rid ourselves of these risks, so why accept them at all?

Lastly, it is important to remember the risk associated with a diversified portfolio impacts us periodically. Through proper planning, we can be placed to benefit from these risks long-term.

I would also add, maybe avoid the TAB when it comes to the NFL.

DFA Matrix Book 2022

Dimensional has released their Matrix Book for 2022, which you may download here. Please let us know if you would like to receive a hard copy, in the new double-sized format.

This annual survey of investment performance draws on historical data to look beyond short-term market fluctuations and shed light on the dimensions that explain differences in returns. Includes a feature essay on the dramatic changes the investment world has seen in recent years and how both investors and financial professionals are benefiting from new products and technology in this space.

The difference a day can make

My nephew turned 2 a couple of weeks ago. For his birthday, we went to a petting zoo out in West Auckland where he and his little friends fed goats, chickens and sheep. They seemed to enjoy it.

There was a little pile of gifts on a table; lego sets, toy cars etc. But one gift which made me laugh came from a family friend. He gifted him $50 in a Sharesies investment account. If only we all started so young!

From a certain point of view, that $50 is worth much more to my nephew, as by the time he can get to the money, it would have grown considerably. Maybe that small part of his savings sits there until he buys a car at 16. At this point, assuming an 8% return, it would have tripled to $150. Maybe he takes it out during university when it is more than $200. Or maybe he never touches it until he retires at 65, when it has grown to over $6,000!

It is hard to understate the difference an early start makes in investing. Take KiwiSaver as an example.

If you contribute enough each year, the government will put $521.43 in your account. If you started at age 18, this single government contribution would grow to $19,414 by the time you reached 65. The sum of all of these government contributions is $255,570.

But if you started just a year later, you would miss this $19,414, ending up with $236,156 instead. That's 7.5% less at retirement age for missing one year!

A similar issue comes from investors sitting in default funds, missing out on those important early years' returns. This is why we supported the change to default funds, to get these investors out of cash and into shares.

While the effect of compound interest is more profound over these long time periods, it doesn't mean it is insignificant for those approaching retirement age. With larger net worths and incomes, it is just as important to act quickly at this stage.

Imagine your goal was to save $50,000 each year for 10 years before you retired. Assuming a 5% return, you would contribute $500,000 and earn $128,894 in gains.

If you decided to just put it off for one year, you would have 9 years to save $500,000. Your contributions have gone up to $55,556 each year to catch up. But, despite the same contributions, your gains are now only $112,587. That one year cost you $16,308!

If you wanted the same final portfolio value as expected previously, you would need to contribute $57,035 each year instead. The longer you leave it, the more returns you must forego or make up for with contributions.

Above I've discussed hypotheticals for missing a year of contributions. But the difference due to missing just one day can be as stark. According to this article from CNBC, the best day for the S&P 500 over the last 20 years delivered an 11.6% return in 2008. Not far behind was a 9.4% day in 2020.

If you invested a lump sum, the impact of missing this day at the start or end of your investment timeframe has the same effect. Over time, the effect of missing this single day will only become more pronounced in dollar terms.

As this Dimensional video shows, the impact of missing these periods can have a huge impact on your investment outcome. Investment markets tend to climb in spurts, so putting off your contributions can cost you as much as trying to time the market. Which is why, when it comes to investing, the best time was yesterday. The next best time is today.

So if you're putting off your own financial goals, get stuck in sooner rather than later. Sort out your KiwiSaver too, as a few minutes of work may be worth tens of thousands down the line. And maybe consider as a gift for your younger family members an new investment account. It truly is a gift that keeps giving!