Don't Get Performance-Shamed

01/23/2020 9:07 am EST


Landon Whaley

Editor, Gravitational Edge

The key metric for your portfolio performance in risk adjusted returns, notes Landon Whaley.

Headline risks are everywhere, much like “buy” ratings from Wall Street analysts. As an investor, you must keep human reactions in check so that you’re not drawn into narratives that promise to unveil the mystery of financial markets. This week’s “Headline Risk” comes courtesy of the fever-pitch bullishness that is running rampant from Main Street to Wall Street, all the way to 1600 Pennsylvania Avenue.

A couple of weeks ago, it was the head of Merrill Lynch’s Wealth Management Division, Andy Sieg, telling people the S&P 500 is going rally 20% in the first six months of 2020 and that they should give the bond allocation in their portfolios the Old Yeller treatment. Now the President of the United States is goading people on Twitter, saying that if their portfolios are only up 50%, then something is wrong! Folks, I could not make this up if I tried.

I think we all need to pump the brakes, take a collective deep breath, and evaluate the realities of U.S. equity returns over the last two years.

Let’s begin with everyone’s favorite benchmark, the S&P 500. The S&P 500 has gained 24.1% cumulatively over the last two years while experiencing a 19.3% drawdown. If we apply our reward-to-risk filter (R-2-R) to this return, we get an R-2-R reading of just 1.3-to-1. This reading means that over the last two years, you’ve experienced $1 of downside risk to earn $1.30. Not nearly as impressive as the media and the Old Institution would have you believe.

The performance stats for the greatest stock market on Earth don’t get any better when we dive down to the sector level:

  • U.S. financials have gained 10.4% over the last two years, with a 24.7% maximum drawdown. Ouch! That box score equates to an R-2-R of 0.42.
  • Basic material stocks have barely eked out a gain (1.2%) but experienced the same 24.7% drawdown. The R-2-R is a barely perceptible 0.05.
  • Industrial stocks have rallied 10.5% over the last 24 months and have also dropped 24.1%, giving them an R-2-R of 0.44.

The metrics get a bit better when we look at the tech, consumer discretionary, and health care sectors:

  • Tech stocks have led the way with a 49.0% return but also experienced a 23.8% drawdown. This gives them an R-2-R of 2.0, which is fantastic if you can handle the volatility.
  • Consumer discretionary stocks have gained 25.5% with a 21.4% drawdown, or an R-2-R of 1.2.
  • Health care stocks have also performed respectably, putting up a 24.4% return with just a 15.4% drawdown (R-2-R of 1.6).

You may be wondering, what about the two sectors you’ve been shamelessly promoting for the better part of the last two years Landon?

I’m glad you asked!

Real-estate Investment Trusts (REITs) have gained 30.1% (third best sector performance), experienced a 12.7% drawdown, and earned a two-year R-2-R of 2.4 (second-best sector R-2-R).

Your grandpa’s stodgy utility stocks have been the best sector from an R-2-R perspective (4.7) and the second-best from a return perspective (41.0%), and they accomplished all of this with just an 8.7% maximum drawdown!

The headline risk bottom line is that unless your 401k is in a few select stocks, then you aren’t up 50%, 70%, 80%, or 90%! Not even an investor that missed the Q4 2018 crash by moving their entire portfolio to cash at the Sept. 21, 2018 high in the S&P 500, and then buying back in at the Dec. 24, 2018 low.

Let’s keep it real here, no one on the planet nailed that pivot. Though for the record, we did call for the Q4 2018 crash in U.S. equities on Sept. 17, 2018, four days before the S&P 500 peaked at a brand new all-time high and proceeded to swan dive 19.3%. Just saying.

Don’t let POTUS, or anyone else, performance-shame you. Your objective should be high single-digit returns (or better) with low single-digit drawdowns, each calendar year, regardless of economic or financial market conditions. If you maintain this absolute return mindset when all about you are losing their minds, your full-cycle returns will trounce the vast majority of investors, and you won’t have stomach ulcers from riding the epic drawdowns that are certain to occur along the way. 

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