Beware the sales pitch of “downside protection”

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Ben Felix

By Ben Felix, PWL Capital Inc.

Special to the Financial Independence Hub

I often hear the phrase protect your downside. It’s the sales pitch that a large part of the investment management industry thrives on, and it plays to the myopic loss aversion that most investors exhibit.

Myopic loss aversion is the tendency of investors to evaluate their portfolios frequently with greater sensitivity to losses than gains, causing them to act as if their time horizon is much shorter than it actually is.

Let’s look at the example of John, who wants to invest for his retirement 30 years from now. After happily watching his portfolio increase with steady returns for a few years, he panics when the market trends down slightly for a week. He knows he doesn’t plan to touch the money for a long time, but the thought of a decline, even over a relatively short period of time, makes him feel sick. He may even pull his money out of the market until things feel safe again.

Myopic loss aversion

An obvious path to safety would seem to be hiring a person or a company that knows how to protect your downside, and the investment industry has answered this calling. John Wilson’s Sprott Enhanced Equity Class “provides downside protection through the use of option strategies and tactical changes to the amount of its equity exposure ….”  while Cecilia Mo, MBA from Dynamic Funds “focuses on delivering consistent strong performance while providing downside protection”.

If these sales pitches were not enough to satisfy our myopic loss aversion, Jeffrey Burchell, Portfolio Manager and Co-CIO for Aston Hill Asset management. makes it clear that he’d “rather make less money than lose money!”

Downside “protection” adds costs

These sales pitches may give confidence to the naive investor, but downside protection strategies inevitably add significant costs to the portfolio over the long-term, resulting in performance that lags a benchmark index. The funny thing about this is that over long periods of time, say 10+ years, global financial markets have tended to increase in value.

Let’s reflect on that; we are accepting additional costs and underperformance to avoid short-term declines, but we have a long-term goal, and over long periods of time the short-term declines are just noise because the market tends to increase in value given a long enough period of time. Many portfolio managers will have you believe it makes sense for long-term investors to accept lower returns in order to avoid being witness to short-term, albeit unrealized, losses; this sentiment can’t be expressed any more explicitly than “I’d rather make less money than lose money!”

What’s an investor to do? The risk of losing your money is only real if you need to sell investments while they are worth less than what you bought them for. Investing requires putting thought and care into matching your portfolio with the time horizon associated with it. If a short-term loss is intolerable because you might need the money soon, then investing in stocks and bonds is probably not the appropriate course of action.

As for using options and tactical allocation for downside protection, long-term investors are better off minimizing their costs and capturing the returns of the global markets using index funds and ETFs. If short-term declines cause an emotional issue, you can simply increase your exposure to bonds.

Benjamin Felix is an Investment Advisor with PWL Capital in Ottawa. He completed an MBA in Financial Management from Carleton University in 2013, and is a 2016 Level III Candidate in the CFA Program. He helps Canadians make smart financial decisions, and manages their portfolios. This article originally ran on pwlcapital.com, and is reposted here with permission.

 

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