Don’t Neglect the Path Traveled
Robert Frost ends his poem “The Road Not Taken” with the iconic lines:
“Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference”
For investors, the path their portfolios travel can make all the difference as well.
There are three portfolio statistics that will help you measure whether your portfolio will provide you with a smooth journey:
- Maximum drawdown
Everyone understands performance—that's the return a portfolio needs in order to meet an investor’s financial goal (for most, a comfortable retirement). Yet, many investors don’t fully account for the path traveled, and the related effects it can have on their portfolios. The biggest obstacles here are typically volatility and maximum drawdown. By employing strategies to mitigate the effects of these obstacles on their portfolios, investors can feel more confident and in control of their financial futures.
The impact of overall portfolio volatility
Bouts of volatility can upend even the most in-depth financial plan. If their investment path is too volatile, an investor can feel off course and will often abandon their plan to start a new one. Put simply, volatility describes how large the price swings are in any given security. According to Investopedia, volatility is “commonly measured by standard deviation, with lower readings implying lower volatility or price swings.”
Most investors seek an experience like a well-planned road trip, where the carefully chosen, efficient route you selected will get you to your destination. If you get off-course from it, your GPS, Google or even a good old fashioned paper map is there to set you straight.
Unfortunately, the experience that most investors actually have feels more like a spontaneous night drive: you can only see a bit in front of you thanks to your headlights and you don’t have the time or attention to mess with maps in the dark. You have to trust you have picked the right road to get you to your destination—even though it doesn’t always feel right.
That uncertainty leaves investors vulnerable. Without a clear view of the long-term path, greed and fear kick in and tempt investors to pick a different plan altogether. And those instincts usually win.
Drawdowns make catching up harder to do
A drawdown is a measure of the depth an investment falls to from its all-time high. In stocks, those drawdowns can be very deep. In bonds, drawdowns tend to be shallow.
Either way, drawdowns are like obstacles on the road. Typically, they’re easy to recover from. A well-diversified portfolio reduces drawdowns so they’re more like an everyday pothole. On the other hand, a volatile portfolio can quickly turn a drawdown into a giant sinkhole.
This is partly why investors abandon investments after drawdowns all the time. They do this because:
- drawdowns leave portfolios further behind than they anticipate
- suffering through large downturns makes even the upside seem like not enough
Large downturns have portfolios suffering from volatility drag: a mathematical principle that shows you have to make up more than you lose in order to break even.
For example: if you start with $100 and lose 20% you’re left with $80. Then, if you manage to make 20% on the remaining $80, you’re only back up to $96—not back to breakeven.
Add onto that the effects of prospect theory: the more you look at your portfolio, the worse your performance seems to be – even when it’s doing well. It’s no wonder drawdowns can make the path traveled so daunting. This free online tool can help you visualize what drawdowns look like in your portfolio.
Balance toward your goals
Since we started with a poem, we’ll end with one too. In Robert Burns’ “To a Mouse” he says:
“But little Mouse, you are not alone,
In proving foresight may be vain:
The best laid schemes of mice and men
Go often askew,
And leave us nothing but grief and pain,
For promised joy!”
All investment plans will face times of uncertainty. The markets are simply too unpredictable and the future too uncertain not to knock any plan off course. That is what makes the path traveled so challenging to navigate.
Still, a balanced portfolio can help keep basic instincts in check and create the smoothest path toward achieving investment goals. Think of diversification as AAA for your investments– a small extra price to pay but when you need it, it’s invaluable.
By employing a strategy of diversification to avoid large price swings and fear-inducing drawdowns, investors can feel more confident and in control of their financial futures.