Can Risk Management Boost Returns? Hint: Yes

This is the second of two emails I recently sent to my fellow finance committee members (of a local non-profit organization). The topic we have been discussing is the investment performance of the organization’s endowment. The points in this message apply just as much to retirement investors as they do to charitable endowment or foundation investors…

One last comment on endowment returns and strategy. Our discussions of managing risk shouldn’t be taken as code for “willing to accept small returns.” The truth is, playing defense can be an effective way to boost returns.

Winning strategies almost always contain an element of sacrifice. A football team will run the ball, repeatedly and ineffectively, to open up the passing game later. Casinos offer gigantic progressive jackpots to lure you into a bank of slot machines. Letting small forest fires burn naturally can prevent hugely destructive fires later.

One factor that allows roundabout strategies like these to work is the difficulty of pulling them off. Fans yell at you for calling plays like a moron. Paying out a big jackpot wrecks the slots manager’s P&L for a few days. Sacrifice, even when it’s well thought out and planned in advance, almost always feels wrong while it’s happening.

To most investors, the obvious route to better performance is through more aggressive concentration in growth assets. You can make a lot of money doing this, the hard part is keeping it. The less obvious strategy is being willing to sacrifice, what looks like easy money now, in return for gaining the earning potential of playing defense. Of having some way of avoiding large losses in order to allow more capital to be conserved and available for compounding.

For example, let’s compare a set of hypothetical market returns to a set of hypothetical returns from a risk managed approach:

hyporeturns

In this illustration, the market outperforms the risk-managed portfolio in nine out of ten years, some of those years by quite a bit. The managed portfolio has three negative years compared to only one for the market. Part of the reason for the persistent lag in the managed account is undoubtedly due to fees, so obviously the value of management is in question. But when you run the math over the entire period:

  • Market total return = +50%
  • Risk-Mgd total return = +60%

The moral of the illustration is that it’s not how often you match or beat the market that matters, it’s when you do it and by how much. In this example, playing defense in year five more than makes up for the relatively meager performance in every other year.

If our committee had coordinated the Risk-Mgd approach above, it would be easy to look back at ten years of completed returns and feel smug about the wisdom of it all. But in the real world, we would probably have spent 90% of the time feeling frustrated and talking about making changes.

I think the key for us is to not care about the market. Our focus should be on preserving and growing the endowment and doing our best to ensure that it can support the mission of the club when it needs to. That’s the only benchmark that really matters.

 

Disclaimer: The above example is hypothetical and is for illustrative purposes only. No specific investments were used in this example. Actual results will vary . Past performance is not indicative of future returns. Information displayed is taken from sources believed to be reliable but cannot be guaranteed. All indices are unmanaged and investors cannot invest directly into an index. Ideas and opinions expressed in this article are the sole responsibility of Patrick Crook/PLC Asset Management and do not reflect any stated opinions of Commonwealth Financial Network, National Financial Services LLC or any other person or entity.

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About Patrick Crook

Pat Crook is a financial advisor in Corvallis, Oregon with over twenty years of experience. He has developed a specialized form of investment portfolio management designed to address the risk concerns of those in or near retirement as well as organizations like charitable endowments and foundations. To learn more or set an appointment, he can be reached at 541.753.1808.