The Tortoise and the Hare
Wealth is ephemeral if risk management is ignored. Focussing on risk management is about treating investing as a marathon, not a sprint.
Global equity markets finished the calendar year on a sombre tone. The US market (S&P500) returned -19.4% for the calendar year, troughing at -24.9% in October. Only the recession years of 2002 and 2008 were worse than 2022. The Australian market (ASX300) fared much better, falling only 1.8% as it was saved by the large index weighting to the Resources index, which returned +20.9%.
The pressure on equity markets in 2022 is analogous to Aesop’s fable, the Tortoise and the Hare. This story captures the essence of many high-flying stocks that collapsed after they reached stratospheric heights two years earlier.
In the United States, the ARKK Innovation Fund (ARKK), renowned for investing in disruptive, high-growth companies, captured headlines when it returned a staggering 149% in 2020. On the other hand, Berkshire Hathaway (BRK), run by the legendary Warren Buffet, returned a paltry 2% in the same year. The returns from ARKK were so strong that since its inception in 2014, it generated about 4x more capital than BRK at its 2020 peak. At that time, it seemed like an impossible task for BRK to outperform ARKK.
However, in 2022, ARKK lost two-thirds of its capital while BRK had another paltry year and returned 4%. After several years of underperforming, BRK is now ahead of ARKK in the investment race.
Source: Iress, Vertium
Like Aesop’s fable life lesson, there is an investment lesson from ARKK and BRK. In the long run, generating long-term returns is a marathon and not a sprint. Maximising upside risk (the sprint) is not as important compared to minimising downside risk (the marathon). A simple exercise of creating an index that excludes the 10 worst-performing months and comparing it to an index that excludes the 10 best-performing months from ASX300 return calculations highlights this key insight.
Source: Iress, Vertium
Over three decades, the ASX300 grew by 15x. However, eliminating the worst-performing months significantly outperformed the benchmark by nearly 3x. On the other hand, excluding the best-performing months underperformed the same benchmark by about half. The evidence highlights that losses have a greater impact than gains on long-term returns. Hence, managing downside risk is critical to protect long-term wealth.
However, investors sometimes lose sight of why risk management is important because at times the stock market does not experience too many corrections. When the rising tide lifts all boats, the frequency of down months is dramatically low. These euphoric periods were clear in the five years leading up to the 2000 Dot-com bust, 2008 Global Financial Crisis, and more recently 2022 stagflation bust.
However, an apt quote by Warren Buffet reminds investors that it’s the long game that counts.
“You don’t find out who’s been swimming naked until the tide goes out”
While the Australian stock market has been very resilient, it is no doubt undergoing a market correction like the US market. The market correction started in late 2021 where both equity markets have experienced an increasing number of down months since. Currently, the percentage of down months over a rolling five-year period is approaching the long-term average of 36%. However, it is not near the 50% that was experienced in the recessionary environments of 2002 and 2008.
As we enter 2023, the recession drumbeats are growing louder. There is no escaping the fact that to control inflation Central Banks must slow economic growth. The next phase of the bear market will most likely be associated with earnings downgrades. While many stocks have derated based on rising interest rates, risk premiums have not significantly expanded, which would offer a margin of a safety cushion to absorb any earnings risk.
In any given year, owning the best-performing stocks can be highly satiating. But many high-flying stocks encounter turbulence on many occasions. Wealth becomes ephemeral if risk management is ignored. Focussing on risk management is about treating investing as a marathon, not a sprint. Hares do run rings around tortoises, but in the end, the tortoise always wins.