Wednesday, February 10, 2016

Avoiding Bear Markets to Improve Risk-Adjusted Returns

Ben Carlson of A Wealth of Common Sense has a recent post, When Global Stocks Go On Sale, outlining that it is typically a pretty good time to be buying when the MSCI World stock index is in a 20% or greater drawdown.

His insightful takeaway and chart outlining the historical drawdowns and forward performance of the index is below:

There were only two times out of the ten bear markets where stocks weren’t higher one year later. Only once were stocks down three years later. And there was never a period where stocks weren’t higher five years after initially falling 20%. The paradox of investing is that the best times to put your money to work are often when things seem like they’re never going to get better.

While I in no way disagree with his insight, especially for a buy and hold investor thinking of selling, I thought it would be fun to share the completely opposing strategy that avoids these periods of distress, as well as one that avoids stock exposure after even one month of negative performance.

Avoiding Extended Drawdowns May Improve Risk Adjusted Returns

As I outlined in a previous post, Using "Normal" Drawdowns as a Timing Signal, an investor who sold their S&P 500 allocation whenever the S&P 500 index was in a drawdown of 10% or more, and instead held bonds, had similar long-term returns as a buy and hold investor, but with materially less risk and drawdowns.

A similar situation has played out for investors allocated to stocks within the MSCI World index when drawdowns were less than 10% or U.S. treasuries when the MSCI World was in a drawdown greater than 10%, while a 20% threshold wouldn't have held up quite as well as the 10%, but would have provided roughly similar returns with less risk than a buy and hold investment.

What gives?

The reason for the improved risk-adjusted performance has been the power of momentum within the MSCI World index during drawdowns. When the MSCI World index ended a month at a roughly 10% drawdown, it often moved lower... sometimes much lower. At a 20% drawdown, only 2 of the 5 times was this in itself a decent short-term buying opportunity (highlighted in green). The other 3 times presented a better opportunity further down the road.

Buying Only at the Peak

Taking this "drawdown avoidance" to the extreme, let's see how an investor in the MSCI World index would have performed if they only bought when it was making new end-of-month highs. In this example, an investor is only holding the MSCI World index if the previous month was at an all-time high, otherwise U.S. Treasuries.

While there were long periods of relative underperformance (and this is an extremely high turnover strategy), the resulting performance and lower risk offers some insight into how a strategy that is less exposed to risk, yet can avoid loss of capital, may actually be able to improve absolute and relative performance.