In the month of January, Black Cypress portfolios delivered strong absolute returns, rising between 2.6% to 4.2%, depending on mandate. Benchmarks rose slightly more.
In the first forty-seven days of 2012, the S&P 500 has risen 8.6%, a figure with which we have thus far been unable to keep pace. We cannot be surprised by our underperformance, as the market has handsomely rewarded the riskier fare, including small, leveraged, non-dividend-paying, and highly-cyclical companies. Large companies underperformed small companies by 2% and “quality” companies underperformed by an even larger margin. To paraphrase Ben Graham, in the short-run the market is a voting machine–in the long-run it is a weighing machine. I am confident that the scales are tipped in our favor.
Ultimately, an investor has to decide which potential investment outcomes–both positive and negative–are acceptable. This requires an understanding of both risk and return, though most focus only on the latter.
In a narrow sense, there are two likely “negative” outcomes for an investor. They underperform the market on the upside or in trying to avoid doing so, they experience large declines which may be accompanied by underperforming the market on the downside. Of course, some managers do both, but that is an altogether different problem. Typically, in seeking to deliver higher returns in every up market, a manager must take greater risk that exposes them to significant drawdown. The other choice, in seeking to protect capital, a manager is at risk of underperforming in significantly rising and overvalued markets.
Understanding these choices and resolving oneself to which is preferred is central to investment success. It is also necessary to grasp our strategy and its long-term merits. The concept of a normal distribution, or the bell curve, will bring further clarification.
The Bell Curve: A “Tail” of Risk
Equity returns are, on average, about 9% per year. But they vary substantially. The measurement of that variation is called the standard deviation, or as investors say, the “volatility” of returns. Most (over 68%) of equity returns fall between -12% and +31% per year. It is outside this vast majority where “tail” risk occurs.
Most discussions of tail risk concern the large negative returns that occur infrequently and are represented on the left side of the bell curve. But what may be obvious is often over looked: by managing the left tail risk, an investor becomes exposed to right tail risk–the risk of underperforming the market. We have resolved ourselves to take in stride the periodic frustration that comes with trailing a frothy market, in order to deliver better long-term returns that should come by limiting losses in relative and hopefully absolute terms.
As we commented in October of last year:
“A strategy that places greater focus on capital preservation works so well because math is on its side. Take two portfolios, A and B. Portfolio A rises 100% in year one and then declines by 50% in year two. Portfolio A will finish at the same level it started. Portfolio B does exactly half the returns of Portfolio A. Portfolio B rises by just 50% in year one and declines by 25% in year two. Where does it stand at the end? Portfolio B will still be up 12.5% because although it rose substantially less than Portfolio A in year one (the kind of underperformance that would get most managers fired), it fell half as much in year two and outperformed Portfolio A by 12.5% at the end of two years. Negative returns are much harder from which to recover than merely lagging the market’s strong returns during up markets. For this reason, we should always manage our downside.”
Through January, we have outperformed the S&P 500 by over 1% per year despite the market rising an average 17% per year since June 2009. But at some point, our capital preservation focus will lead to the right tail risk that keeps most investors up at night. We will sleep soundly.
Data continues to signal a growing economy. Real retail sales are firmly above last year, initial claims continue to trend lower, manufacturing is expanding, and housing investment has started to grow, all of which are supported by an accommodative Fed, low interest rates, and tightening credit spreads. Weekly earnings adjusted for inflation is the one weak spot, which is down versus the prior year for the tenth consecutive month. Overall, economic data is positive but not particularly strong.