Warren Buffett has attributed much of his well-known investment success to two rules.
Rule #1: Never lose money. Rule #2: Never forget Rule #1.
What the Oracle of Omaha is reminding us, in a humorous way, is to keep our eye on the return of our capital, even more so than the return on our capital. This is critical for those who are saving and investing for retirement. Capital loss in your investment portfolio can have a huge negative impact on your plans and on your financial security.
Any discussion of capital loss should be linked to two of the ultimate risks that we all need to avoid. The first is wipeout risk, and the second, which is related to it, is shortfall risk.
Wipeout risk is just what it sounds like ‒ losing so much of your capital that you must start over, or nearly so. Wipeout risk leads to shortfall risk, which is the potential of not having enough income to last throughout your retirement or to meet other critical goals. This scenario is truly uncomfortable because it can mean losing your financial independence, or worse.
So it’s vital to understand what can lead to those big, wipeout-level setbacks that we all want to avoid. Having too much of your savings concentrated in one investment is one oversight that can leave you vulnerable to wipeout risk. Another more subtle oversight is to hold multiple investments, but not recognize that they all behave too similarly to economic shocks, leaving you without the diversification you hope for when you may need it most.
Many investors diversify by holding index funds. And that’s a great start, but it’s not enough to just own lots of different investments. You need to own investments that behave dissimilarly, meaning when one investment is going up, another is going down. This may seem a bit counterintuitive for some investors. A strategy built around the notion that you want some of your investments to go down in value? Yes, if the price declines are temporary.
The portfolio smoothing impact of owning securities that have dissimilar short-term price behaviors and the potential to rise over the long term gives you the opportunity to earn the returns you seek, while smoothing out some of the bumps along the way. Price correlation measures how similarly or dissimilarly one investment behaves with regard to another. Measuring is important, because it’s not possible to manage something you don’t measure.
A simple and commonly observed pair of investments that have often behaved differently (low price correlation) are stocks and high quality bonds. In theory, one should rise as the other falls. In practice, finding enough investments that behave differently enough is challenging. And, low correlations can disappear when you need them most ‒ during market panics ‒ when everyone is running for the exits at the same time.
Analyzing the durability of your portfolio’s diversification under different market conditions may yield useful insights about the diversification benefits you may expect from your investments when markets become stressed. This type of study may reveal a path of better-informed investment choices to construct your investment portfolio.
By improving the stability of your portfolio with better diversification benefits, you can help reduce the large declines in value that can lead to wipe-out risk and the follow-on effect of shortfall risk. The payoff for your effort is the prospect of a more secure retirement.
Contact us if you would like help analyzing the durability of the diversification benefits embedded in your investment portfolio. That’s just part of what we do.
