Downside Protection or Upward Enhancement?

A perspective for better decision making when in dilemma to choose between Risk and Return, while allocating one’s resources.

A financial adviser usually dedicates a lot of time for understanding the risk-appetite and return-requirements of the client. Primarily because the investment management industry has always considered that a very high positive correlation exists between risk and reward. However, only in the past few years certain empirical evidence is being collected suggesting that higher return with limited risk is also possible.

But the objective of the article remains to throw more color on the discussion of what could be prioritized if one has the chance — protecting downside or enhancing upside.

To keep the explanations and calculations jargon-free, we can assume that a person has invested an INR 100 in the financial markets, and the next day markets gained by 10% taking up the market value of the person’s investment at INR 110. But a day later due to certain negative news the markets fell by 10% and brought down the investment value to INR 99.

Now let’s take a moment and dive deeper into what just happened. The market went up 10% and then went down 10%, which to must of us would mean that we are back to square one, and there is a situation of no profit or loss. But obviously numbers had a different story to tell, as the value of investments increased by INR 10 but came down by INR 11, taking the value of investments below the invested amount of INR 100.

Even in the case when we reverse the situation such that, the market falls first and then rises by 10%; the value of investments will go from INR 100 to INR 90 to INR 99. At this point, it is to be highlighted that to recover from this fall of 10%, an alpha (technical term for return generated) of 11.11% is required.

Similarly, in cases when the markets fall due to a pandemic or any unforeseen circumstance, a fall of 20%-30% value of the index value does not seem to be very astonishing. But now to reach the same levels from where the index fell, a 20%-30% rise will not adequately compensate for the fall. Rather 25%-42.86% would be required.

The following table explains in greater detail the increasing exponentially increasing alpha which will have to be generated for reaching back the levels of the invested capital, as the market fall deepens.

*returns required for reaching the levels of the amount invested

Another way to look at the same example is that, if we had invested USD 1,000 in any portfolio tracking the S&P 500® in 1970. Then its worth after 50 years, i.e. in the year 2020 the investment worth would have been USD 125,458. But if the best of the 10 days during the 50 year investment period was missed then the portfolio value would have dropped by half to USD 56,389. On the contrary, if we had the privilege of being able to miss the 10 worst days during the investment period, then the portfolio value would have almost tripled to USD 359,233.

But at the end of the day, as capital allocators, it is also to be realized that the maximum downside possible can only be equivalent to amount invested, i.e. 1x but the upside can always remain uncapped. And legendary investors of the likes of Mr. RK Damani, Mr. Raamdeo Agarwal, Mr. Shankar Sharma are wonderful examples of alpha generators of India.

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