SNAPSHOT2 min read

Why protecting capital in downturns is so important

Keeping losses to a minimum is a key part of the successful investor's toolkit.

14/02/2023
financial-losses

Authors

Simon Barker
Portfolio Director

Warren Buffett once quipped that “the first rule of investing is: 'don’t lose money!' The second rule is: 'don’t forget the first rule'.” Unfortunately, it is impossible to avoid losses at all times – as even the Sage of Omaha knows. However, the adage is a useful reminder that minimising losses plays a crucial role in generating strong returns over the long term. It was a particularly challenging task in 2022 when both global equities and bonds both fell by close to 20% (in USD terms). Only a handful of assets either held onto or increased in value.

The maths: why protecting capital is so important

Unfortunately, a loss cannot be made up for by a gain of the same percentage amount. If a £100 portfolio loses 10% of its value, it will be worth £90. If it then rebounds by 10%, it would only be worth £99 – and less than its initial value. You would in fact need a gain of 11.1% to get back to your starting point. For bigger losses, the uplift in the return that you need to get back to square one is even greater: a 50% loss requires a 100% gain. Such dramatic falls are thankfully rare for investors in a diversified portfolio. Mathematically, however, a loss of any size requires an even greater percentage return to recover, as illustrated below. This fundamental law of investment means that investors should always be focused on the risk of loss.

607461_protecting_capital_fig2

Protecting capital also helps when it comes to the other part of the return equation: gains. By avoiding losses, positive returns build from a higher base and are worth more in actual monetary terms – a 10% return on £100 is worth more than 10% of £95. In any one year, these effects may appear minimal but they build up over time.

Of course, a focus on minimising losses is not cost-free. In general, taking less risk in a portfolio will mean that you generate lower returns when markets rally. The “holy grail” for managers, therefore, is to protect capital effectively through drawdowns without giving up too much of the recovery. This is a key part of our fund selection process: we closely monitor managers’ ability to harvest market gains while keeping losses low.

An illustration

Getting it right can make a powerful difference in returns. We have looked at returns for the FTSE All Share (including dividends) over the past twenty years. The blue line shows how the index actually performed; the orange is an illustration of the additional return that would come from reducing losses in negative quarters by just 10%. So if the index fell 5% in a given quarter, our imaginary index would have fallen by 4.5%. Over the 20 year period, this increases the total return by around 20% and the annualised return to 7.1% from 6.1%. A very modest reduction in losses drives quite a significant improvement in performance over the longer term.

607461_protecting_capital_fig1

Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

Source: Cazenove Capital

Our track record of protecting capital

Portfolios managed by Cazenove Capital have a strong track record of managing drawdowns. In the turbulent first three years of the 2020s, ARCs Steady Growth Private Client Index experienced 17 losing months. Cazenove Capital’s core growth strategy outperformed in 15 of these negative months (88%). Our core balanced portfolios outperformed in 10 out of 15 negative months (67%).

This includes a relatively strong performance in 2022. Over the course of the year, our core balanced and growth strategies outperformed their peer groups by 1% and 2% respectively.

Following the invasion of Ukraine, we were quick to recognise that the risk of “stagflation” – a period of high inflation and low growth – had significantly increased. Historically, this has not been a good environment for equities and it prompted a tactical decision to cut our overall equity exposure in the first half of 2022. At the same time, we reduced our exposure to small and medium-sized companies in favour of larger companies with strong balance sheets and pricing power.

We also benefited from our long-running preference for alternative investments over fixed income. Being underweight bonds was uncomfortable for much of 2020 and 2021, but our perseverance was rewarded last year.

No investor gets it right all the time. However, in recent years, we have been effective in protecting capital through market downturns. In any given month or year, the differences in performance may not appear huge. But as the data above illustrates, over long periods of time these small differences can make a very significant difference indeed.

 

Where FTSE International Limited (“FTSE”) data is used, “FTSE” is a trademark of the London Stock Exchange Group of companies and is used by FTSE International Limited under license. All rights in the FTSE indices vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices or underlying data. No further distribution of FTSE data is permitted without FTSE’s express written consent.

This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.

All data contained within this document is sourced from Cazenove Capital unless otherwise stated.

Authors

Simon Barker
Portfolio Director

Topics

The value of your investments and the income received from them can fall as well as rise. You may not get back the amount you invested.