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Mathematics of Winning & Losing

Any loss sustained in one’s portfolio requires a greater return to get back to the original starting point. A twenty percent loss will require a twenty five percent return on remaining principal to get back to the starting value. For example, look at these two hypothetical situations first from a rebounding market and a then from a declining market.

Rebounding from a market decline: $100,000 starting value - 37.6% cumulative decline You will need a 60% return to get back to $100,000

Approaching retirement, look what happens when withdrawals are taken during a market decline: $100,000 starting value 5% withdraw rate each year for retirement - 37.6% cumulative decline. You will need a 87% return to get back to $100,000 if you take a 5% withdraw.

Drawdown - Why We Use It

The concept and term of drawdown may be new to many investors, but it is an important factor we at Provident use in our analysis of any investment strategy and within the portfolio as a whole. From a risk-management perspective, drawdown and the mathematics of winning and losing are closely related.

Drawdown is the decline in value from the peak to the trough over a specific time and is usually quoted as a percent. For example, if your investment amount was $100,000 and you lost $50,000, this would represent a 50% loss in value for your investments. Your account equity, the amount remaining, is $50,000 after the drawdown. You will need a gain of $50,000 to bring your investment back to $100,000.

How much gain do you need to bring your remaining investment back to original? If your answer is 50%, then it is wrong, because 50% of $50,000 (account equity after drawdown) is only $25,000, and that would take your account back to only $75,000. You would still be behind $25,000 from your initial investment. So the correct answer is 100%, that is, you will need a 100% return of the remaining $50,000 to bring your investment back to the original position. In summary, this simple example demonstrates that if you have lost 50% of your investment, in this case, then you need 100% gain to restore the financial position of your account to the original position.

The picture below is worth a thousand words and explains the concept very clearly for those of us who are more visually gifted. As you can see, the S&P 500 has suffered relatively large drawdowns over the last ten years, -49% and -57% from March of 2000 to October of 2002 and from October 2007 to March of 2009, respectively. Since no one has a crystal ball, we do not know what the peak or trough (top or bottom) will be until it is behind us.

Big drawdowns can take a long time to recover one's account back to the original principal amount. It took almost five years (5 years!) to recover from the drawdown of the the S&P 500 after the dot com bubble, and we have not fully recovered from the drawdown in the S&P 500 that bottomed out in March of 2009.

It is for this reason that active risk management is critical to long-term success when it comes to investing. Many of us, especially retirees, do not have five years to wait for our investments to get back to breakeven. There is also the lost opportunity of time, with respect to compounding the growth of capital and not just compounding the capital to get back to even.

Drawdown can be thought of in simple terms as one's pain threshold. If you have $10,000 and it dropped to $8,000 (20%), would you still be able to sleep at night? What if you opened your statement and it was down $5,000 (50% drawdown) in equity value? As drawdown is a percentage-based measure that one can directly associate with their investment account value, it provides a meaningful sense of the risk one is willing to accept. Since we have all lived through two drawdowns of approximately 50% in the last ten years, when looking at the S&P 500, we know what it feels like and how long it has taken to recover. When looking at investments, be sure to consider drawdown.

Disclaimers: Drawdown is a measurement tool, but is not the only risk-measurement tool. Historical drawdowns of and investment, index or strategy does not necessarily represent future drawdowns, performance or offer predictive value for what may happen in the future. No one on the planet has a crystal ball or can say that low drawdown or high drawn investment will continue to operate in the exact same manner.

Market Volatility: Looking for Opportunity

In Chinese, the word "crisis" is composed of two parts. One symbolizes "danger"; the other represents "opportunity." If you can keep your head while all around you are losing theirs, you may be able to take advantage of remarkable opportunities. Though all investing involves risk, including the possible loss of principal, and there can be no guarantee that any strategy will be successful, your financial professional may be able to help you decide if any of the following may be appropriate for you.

Rebalancing at a discount
If you rebalance your portfolio periodically to try to maintain a certain percentage of your assets in a variety of investment types, market volatility might offer a good opportunity to consider your level of diversification. Rather than abandoning a single asset class entirely, you might look at adjusting your portfolio in a way that spreads your bets across a wider range of asset classes. Though diversification can't guarantee a profit or insure against a loss, of course, it might help better position your portfolio for the future. And the silver lining to indiscriminate broad-based market turmoil is that depending on the types of investments you want to add to your portfolio, you may be able to acquire them at a discount.

Being willing to use tough times
Anyone can look good during bull markets; being able to learn from a volatile market can better prepare you for the future. Sometimes the best strategy is to take a tax loss if that's a possibility, learn from the experience, and apply the lesson to future decisions. There are other ways to wring some benefit from a down market. If you've been considering whether to convert a tax-deferred plan whose value has dropped dramatically to a Roth IRA, a lower account balance might make a conversion more attractive. Though the conversion would trigger federal income taxes, that tax would be based on the reduced value of your account. A financial professional can suggest whether and when a conversion might be advantageous. Also, some sound research might turn up buying opportunities on investments whose prices are down for reasons that have nothing to do with the fundamentals.

Playing defense
During volatile periods in the stock market, many investors reexamine their allocation to such defensive sectors as consumer staples or utilities, which tend to experience relatively stable demand for their goods and services whether the economy is doing well or poorly (though like all stocks, those sectors involve their own risks). Businesses in defensive sectors aren't immune from economic hard times, overall market movements, or problems within individual companies. However, the ups and downs of stocks considered "defensive" have generally been a bit less dramatic than in sectors where revenues are heavily affected by the economic climate (past performance is no guarantee of future results, of course). Dividends also can help cushion the impact of price swings. Dividend income has represented roughly one-third of the average monthly total return on the Standard & Poor's 500 stocks since 1926.

Using cash to help manage your mindset
Holding cash and cash alternatives can be the financial equivalent of taking deep breaths to relax. It can enhance your ability to make thoughtful investment decisions instead of impulsive ones. A cash position coupled with a disciplined investing strategy can change your perspective on market volatility. Knowing that you're positioned to take advantage of a downturn by picking up bargains may increase your ability to be patient.

That doesn't necessarily mean you should convert your entire portfolio into cash. A period of extreme market volatility can make it even more difficult than usual to pick the right time to make any large-scale move. Watching the market move up after you've abandoned it can be almost as painful as watching it go down. And are you sure you'll be able to pick the right time to move back into the market? Finally, an all-cash portfolio may not keep up with inflation over time; if you have long-term goals, consider the impact of a major change on your ability to achieve them. An appropriate asset allocation that takes into account your time horizon and risk tolerance should provide you with enough resources on hand to prevent having to sell stocks to meet ordinary expenses or, if you've used leverage, a margin call.

Checking your withdrawal rate
If you're retired and relying on your investments to produce an income, market volatility can be especially challenging. If your nest egg has shrunk as a result of market turmoil, you may need to rethink the rate at which money is taken out. If you currently increase the amount you withdraw from your portfolio each year by enough to account for inflation, you may be able to do away with those increases for a year or two, especially if inflation is relatively benign.

If you're withdrawing, say, 4% of your portfolio per year but you're concerned about losses, you might consider not automatically withdrawing the same dollar amount in upcoming months. Instead, you could base your 4% withdrawals on your portfolio's current value and withdraw that amount. For example, if you've been withdrawing 4% of a $1.2 million portfolio that is now worth $900,000, you could withdraw $36,000 next year--4% of $900,000--instead of the previous $48,000. You also may want some expert help in determining whether your withdrawal rate itself--the percentage of your portfolio you withdraw each year--needs to be adjusted. Trimming your budget or finding additional income sources might help you avoid having to sell at an inopportune time.

Staying on track by continuing to save
Regularly adding to an account that's designed for a long-term goal may cushion the emotional impact of market swings. If losses are offset even in part by new savings, the bottom-line number on your statement might not be quite so discouraging. If you're using dollar-cost averaging--investing a specific amount regularly regardless of fluctuating price levels--you may be getting a bargain by continuing to buy when prices are down. However, you'll also need to consider your financial and psychological ability to continue purchases through periods of low price levels or economic distress; dollar-cost averaging loses much of its benefit if you stop just when prices are reduced. And it can't guarantee a profit or protect against a loss.

If you just can't bring yourself to invest during a period of uncertainty, you could continue to save, but direct new savings into a cash equivalent investment until your comfort level rises. Though you might not be buying at a discount, you'd at least be creating a pool of money to invest when you're ready. The key is not to let short-term anxiety make you forget your long-term plan.

The use of this newsletter is subject to terms and conditions specified herein. If you are unable or unwilling to agree to terms as stated do not use the newsletter. The newsletter is just the opinion of the writer and should not be construed to be anything more than opinion. You are free to agree or disagree with the writer of the newsletter. The material in this newsletter is intended to be informational only and should not be considered to be investment recommendation or professional advice regarding investments. The material should not be used as a basis for investment decisions. Investment decisions are highly personal decisions and depend upon a number of factors including but not limited to age, financial situation, investment objectives, financial acumen and risk tolerance. You are solely responsible for determining whether you wish to make a particular investment or pursue a particular investment strategy. The material in the newsletter is not tax or legal advice. We are not licensed attorneys or CPAs. If you need legal or tax advice you should personally consult an attorney or CPA regarding your specific legal or tax situation. The nature of markets is that they change constantly. The information contained in this newsletter is only presented as of the date of the letter and the information may become out of date. Provident does not assume any obligation to update the newsletter or any of the information contained in the newsletter. This newsletter is protected by applicable copyright laws. You may not copy, distribute, modify, post or otherwise use material in the newsletter without prior written consent of Provident.

Risk and High Correlation

Why The Absolute Approach Works.

What our research has found is that the most common method of allocating assets over the past few decades offers little diversification benefits to investors and in most cases exposes them to directional market risk that is under appreciated by many professionals and individuals.  Moreover, investors take on too much risk.

We have created a helpful heat map of typical investment asset classes.  The scale below shows that highly correlated assets in red (move together), inverse correlated assets in green (move opposite) and non-correlated assets in blue (move independently). Ideally one would want as many non or extremely low correlated assets in a portfolio as their performance, good and bad, is independent of the others.

Step 1:  True Diversification comes from non-correlated assets and strategies: This is where we start.

Step 2:  We rank each candidate by a Three Step Quantitative approach:

Step 3:  Overall Trend

In order for an investment to be included in our index it's price must be above trend.

Step 4:  Revisit and Re-balance Often

The world we live in changes constantly.  Having an approach to hold an investment for years flies in the face of common sense and sound risk management principles. Our indexes are re-balanced at least monthly.

Below is a correlation study of the most common allocation of equities in a traditional portfolio.  As you can plainly see the correlation between theses various stock groupings is high.

In order to achieve greater diversification as ascribed by Modern Portfolio Theory, PCM has developed a mix of non or low correlated strategies that can be used individually in an portfolio or combined to decrease directional market risk.  A strategy is nothing more than an approach of buying and selling any investment.  Buying a stock or traditional mutual fund is a strategy where gains are made when the price increases and losses occur when the price decreases relative to ones purchase price.  If you are an investor, you are using a strategy whether you know it or not.   Buying growth stocks, international ETFs, or value stocks is a strategy.  Buying bonds is a strategy.  How you execute the strategy is a separate topic in and of itself.

Below is a heat map of Provident Capital's Absolute Indexes.  Take note the the overall correlation between the various indexes is low.  Much lower than the traditional approach above even though the indexes use many if not all of the traditional indexes above. This is where the philosophy and execution of a strategy make a difference.

What's Working Short Term:

What's Working Intermediate Term:

Volatility: There is a direct correlation to high volatility and subsequent drawdown.  In order to minimize the potential risk Provident's quantitative analysis screens out investments that demonstrate higher volatility.

PCM's Absolute Portfolio Approach

Step 1:  True Diversification comes from non-correlated assets and strategies: This is where we start.

Step 2:  We rank each candidate by a Three Step Quantitative approach: 

Step 3:  Overall Trend

In order for an investment to be included in our index it's price must be above trend.  

Step 4:  Revisit and Re-balance Often

The world we live in changes constantly.  Having an approach to hold an investment for years flies in the face of common sense and sound risk management principles. Our indexes are re-balanced at least monthly.

Why The Absolute Approach Works.

What our research has found is that the most common method of allocating assets over the past few decades offers little diversification benefits to investors and in most cases exposes them to directional market risk that is under appreciated by many professionals and individuals.  

We have created a helpful heat map of typical investment asset classes.  The scale below shows that highly correlated assets in red (move together), inverse correlated assets in green (move opposite) and non-correlated assets in blue (move independently). Ideally one would want as many non or extremely low correlated assets in a portfolio as their performance, good and bad, is independent of the others.  

Below is a correlation study of the most common allocation of equities in a traditional portfolio.  As you can plainly see the correlation between theses various stock groupings is high.  

In order to achieve greater diversification as ascribed by Modern Portfolio Theory, PCM has developed a mix of non or low correlated strategies that can be used individually in an portfolio or combined to decrease directional market risk.  A strategy is nothing more than an approach of buying and selling any investment.  Buying a stock or traditional mutual fund is a strategy where gains are made when the price increases and losses occur when the price decreases relative to ones purchase price.  If you are an investor, you are using a strategy whether you know it or not.   Buying growth stocks, international ETFs, or value stocks is a strategy.  Buying bonds is a strategy.  How you execute the strategy is a separate topic in and of itself. 

Below is a heat map of Provident Capital's Absolute Indexes.  Take note the the overall correlation between the various indexes is low.  Much lower than the traditional approach above even though the indexes use many if not all of the traditional indexes above. This is where the philosophy and execution of a strategy make a difference.  

What's Working Short Term:

What's Working Intermediate Term:

Volatility: There is a direct correlation to high volatility and subsequent drawdown.  In order to minimize the potential risk Provident's quantitative analysis screens out investments that demonstrate higher volatility.

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