What are your re-watchable movies? For me, it’s several cult classics from the mid-90s. It doesn’t matter how many times I’ve seen them, if I happen to catch them when flipping through the channels, I’m going to stop. Unfortunately, I usually end up only watching briefly until my wife rolls her eyes and asks, “Again…really?”
Recently, during my 845th viewing of “Tommy Boy,” I noticed an interesting parallel between Tommy’s description of the guarantee when selling brake pads and the act of wholesaling downside protection to advisors. Indeed, the guarantee does make you feel all warm and toasty inside, but is it really a “guarantee fairy” who’s a crazy glue sniffer?
(As an aside, if that last reference didn’t immediately “click” in your mind, your memory might just need a little refreshing with this clip from the movie.)
In our experience, the financial advisory business appears to fall into two camps as it relates to downside protection strategies in their portfolios:
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CAMP #1 |
CAMP #2 |
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Does not seem to value downside protection at all and is content to bet on generally, if not permanently, rising equity markets |
Prioritizes downside protection since, as it’s been said, by the time you’re hunting around for an umbrella in the middle of a storm, it can be difficult to find one |
We align more easily with camp #2.
For starters, we wonder if the camp #1 folk are avoiding looking at a long-term chart of the Nikkei 225 Index, the benchmark Japanese stock index. It’s currently still below its previous high from – wait for it – 1990! Try telling a Japanese investor that the stock market “always comes back.”
That’s just one way to highlight why we generally agree with the following sentiment from Irving Kahn, founder of the Kahn Brothers Group and Benjamin Graham’s teaching assistant and Columbia Business School:
“Considering the downside is the single most important thing an investor must do.” – Irving Kahn
What’s the Cost of that ‘Guarantee?’
The trouble for some advisors in camp #2 is they can, at times, value downside protection so much that they “overpay” for it, either in terms of fees or opportunity cost in the form of drag on performance. And this does not even include the operational costs of continually monitoring and rolling exposure forward.
Why does this happen? We think it’s the result of some advisors looking for a box with a “guarantee” sticker, which can come in various forms, from do-it-yourself options strategies to structured notes in a liquid wrapper. Many of these strategies entail significant opportunity cost by way of capped upside or a steady drag on performance during increasing equity markets due to option premiums.
This approach looks a lot like that mythical “guarantee fairy” to me.
Offense and Defense, Just No Shiny Sticker
“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.” – Warren Buffett in the Preface of “The Intelligent Investor”
At Blueprint, we think there’s a better way. It doesn’t have a guarantee sticker on the box (our friends in compliance say we can’t say that word anyhow) – but it is designed with the goal of protecting downside and capturing upside.
We utilize rules-based strategies that focus on asset prices to determine final asset allocations, also known as trend following.
Downside protection is at the heart of our strategies, but capturing upside is equally important. It is why our process places no explicit or even implied cap on performance over the long-term during upward trending equity markets.
History shows that no one knows nor can predict how long good periods will last. In our view, capturing these periods is essential to keeping compounding at or near its highest point.
So, in years like 2009, 2013, 2014, 2017, 2019, and now 2021 (YTD), when downside protection isn’t necessary, we will aggressively seek return for our partnering advisors and their clients.
In other words, protecting downside does not have to mean a permanently defensive position. Instead, it shows up in the handful of years when it is needed, like 2008, 2011, 2018, and 2020.
In closing, beware the guarantee. Sure, you may get the warm and toasties, but at what cost? As has been said by many of the greatest investors of all time: What is comfortable is rarely profitable. At Blueprint, we seek a balance between comfort and returns, but neither extreme. The best news of all is we believe following prices and sticking to rules offers the best of both worlds for us, our partnering advisors, and their clients.
Drop us a line if you’d like to discuss.