Defense Wins Championships

Public domain image courtesy of John Van Winkle via Wikimedia Commons

Public domain image courtesy of John Van Winkle via Wikimedia Commons

Investors often take the words “defensive” or “conservative” as code for “being willing to accept small returns.” The truth is, playing defense can be the easiest way to boost your returns.

Most investors focus on offense. Finding the next Tesla or Google. Trying to figure out which sector will benefit most from next week’s GDP numbers. Who’s going to beat estimates and by how much, etc.

The problem with focusing solely on offense is that it’s almost impossible to possess an advantage. You use the same information to try to find the same opportunities as everyone else. For example, let’s say you’re a value investor that wants to find low p/e, blue chip stocks with a high dividend yield. How would you go about that? You might do something like:

  1. Go to a screening tool like Value Line or Finviz or Yahoo Finance, or one of dozens of others freely available on the internet.
  2. Set the filters to show: a) large companies; b) p/e ratio < 10; c) dividend yield > 4%
  3. From those results, select one or more that look appealing.

This would be a fine method for finding stocks that comply with your screen, but what can a screen like this possibly be worth? There is nothing unique or unknown or advantageous about any of the selection variations you can use to find these stocks. Finviz offers 61 different filter elements, from p/e ratio to industry to trading volume, etc. The reason that these elements are offered by Finviz, is because people use them. It’s not difficult to find stocks with a low p/e (or a high p/e if that’s your thing). No matter what combination of factors you choose, it’s already in use somewhere and has been tried countless times in the past. There is too much money chasing the same thing for there to be a persistent edge in information that is free and easily accessible to everyone on the planet at the same time.

Another offensive focus comes from index investors who are content with getting something pretty close to the market average. Since the market usually goes up and everyone knows it’s almost impossible to beat the market with regularity, why not limit cost and effort and just get the average? The logic is rational and the “no work, low cost, long term profits” message is appealing.

Both of these approaches are common. Particularly the index approach – this has become the standard plan. Visit fifty financial planners this month and probably forty nine will recommend the asset allocation/index/occasional rebalance strategy. But both of these approaches miss the earning potential of playing defense. Of having some way of avoiding large losses so the gains you do make are conserved and available for compounding. The effect this has on long-term earnings is not obvious at first glance, but it can be very powerful.

For example, let’s compare a set of hypothetical market returns and the performance from a hypothetical risk managed approach to that market. The numbers aren’t real, but the point is:

Year Market Risk-Mgd
1 +10% +6%
2 +9% +7%
3 +12% +9%
4 +2% -2%
5 -37% -3%
6 +21% +14%
7 +16% +9%
8 +11% +8%
9 +7% +5%
10 +4% -3%

Looks like a tough comparison for the Risk Managed approach. The market outperforms in nine out of ten years. 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 portfolio was undoubtedly due to management fees, so you have to question the value of that. But let’s run the math over the entire period:

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

The message that we’ve all heard about how the vast majority of portfolio managers can’t beat the market on a regular basis is true. It’s also meaningless. It’s not how often you outperform 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 poor performance in every other year combined.

One important key to beating the market is to not care about beating the market. An investor’s focus should be on the relentless march forward. Making progress when odds are favorable and playing defense when they’re not. Most people don’t invest for the pleasure of owning stocks or for bragging rights, they do it to remain financially independent. It’s easier to avoid the noise and distraction of irrelevant market comparisons when you remember that. When you remember the true purpose of why you’re investing in the first place.

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The image above titled “Falcons sack Cowboys QB at AFA at Wyoming” is a work of a U.S. Air Force Airman or employee, taken or made as part of that person’s official duties. As a work of the U.S. federal government, the image or file is in the public domain.

Disclaimer: Investments are subject to risk, including the loss of principal. Some investments are not suitable for all investors. Talk to your financial advisor before making any investing decisions. Past performance is not indicative of future returns. Information displayed is taken from sources believed to be reliable but cannot be guaranteed. When you link to any of the websites provided here, you are leaving this website. We make no representation as to the completeness or accuracy of information provided at these websites. All indices are unmanaged and investors cannot invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance does not guarantee future results. Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved. 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.