What is participation with protection?
Put simply, participation with protection is based on the understanding that when it comes to building wealth and sustaining that growth over time, the impact of preserving capital in falling markets far outstrips the importance of outperforming the market in rising ones. This approach enables investors to participate when the market advances without undue risk and still outperform over time.
By going down less when the market declines, a portfolio grows from a higher base when the market starts to advance again. Protection provides the portfolio with the significant opportunity to regain its initial value faster and begin outperforming the market sooner.
While the price of protection is the possibility of trailing an advancing market to some degree, a well-constructed portfolio is still able to participate strongly in the market's advance, capturing most of the upside without taking excessive risk. Judiciously combining protection and participation typically leads to outperformance over time. This philosophy is behind our Large Cap Equity Strategy™ (LCES), which has a long history of outperforming the S&P 500 gross of fees.
The bottom line is, an investor does not need to continuously seek to outperform the market to build wealth as long as the portfolio is adequately protected during declines. While tempting, a singular focus on outperforming the market can lead investors to take on unnecessary risk that may ultimately cost them in the long run. Not only does the participation with protection approach let one sleep better at night, it actually builds and sustains wealth more effectively.
HOW IT WORKS
Most people quickly recognize that to make up for a 50% loss, their portfolio would need to go up 100% to get back to where they started.
But few realize how powerful minimizing the initial loss can be in rebuilding or exceeding their original investment. In fact, the impact of going down less than the market far outstrips the importance of going up more than the market.
For example, if you were able to reduce your loss by just 5 percentage points – making your decline 45% instead of 50% – your portfolio would need to go up only 82% instead of 100% to get back to where it started. In other words, protecting your capital so that you were able to cut your loss to just 90% of the market decline would put you back to where you started after your portfolio advanced 82% instead of 100%.
If the portfolio advanced by 100% – to where the market regained its starting value – it would have surpassed where it started and grown your wealth by 10%!
Now, imagine if you were able to reduce your loss to 30% instead of 50%. The portfolio would need to go up by only 43% instead of 82% to get back to where it started. In other words, protecting your capital so that you were able to cut your loss to 60% of the market decline would put you back to where you started after your portfolio advanced 43% instead of 100%.
Any advance beyond 43% would mean that you were growing your wealth. And if your portfolio had advanced until the market regained its starting value, you would have grown your capital by 40%.
Protecting your portfolio against decline is among the most effective ways of building long-term wealth because it takes less of a market advance to get you back to your starting value and you begin growing your wealth beyond that starting value much quicker.
As we continue to experience one of the longest bull markets on record, it may be prudent to consider working with a disciplined, experienced manager with a 50-year history of successfully employing a strategy based on participation with downside protection.
PARTICIPATION WITH PROTECTION IN WEALTH MANAGEMENT
Within wealth management, the same participation with protection principles are applied using asset allocation, diversification and rebalancing. Effective diversification across asset classes and rebalancing to that target asset allocation as asset class performance varies not only mutes the portfolio's declines and enables it to begin advancing from a higher base but also enhances the probability of outperformance.
To demonstrate the benefits of participation with protection, let's take three investors, each with $100. The first investor puts all $100 into Asset Class A. The second investor puts all $100 into Asset Class B. Asset Class A goes up 50% in Period 1 and loses 25% in Period 2. Asset Class B loses 25% in Period 1 and goes up 50% in Period 2. At the end of Period 1, the first investor has $150 and the second has $75, but at the end of Period 2, both investors have $112.50 – after very bumpy rides.
The third investor decides to put a 50/50 asset allocation in place: $50 in Asset Class A and $50 in Asset Class B. At the end of Period 1, this investor has a total of $112.50 – having made 50% on the $50 in Asset Class A and lost 25% on the $50 in Asset Class B. The investor now rebalances back to the initial target 50/50 asset allocation, dividing the $112.50 into two so that Period 2 begins with $56.25 in each asset class. In Period 2, Asset Class A loses 25% – becoming $42.19 – while Asset Class B goes up 50% to $84.38. At the end of Period 2, the investor therefore has $126.56 – 12.5% more than either of the first two investors. What's more, although the investor might be disappointed that the 12.5% return trailed the 50% earned by the investors in both Asset Class A in Period 1 and Asset Class B in Period 2, this investor not only made more money than either of the other investors but also experienced a much smoother ride by progressing from $100 to $112.50 to $126.56.
That's participation with protection in action for wealth management. We apply the third investor's strategy, asset allocation-driven investing, to our private client portfolios. By analyzing historical standard deviations, returns and correlations across multiple asset classes, investors can create portfolios that offer the most efficient combinations of asset classes, those that have the greatest return for the least downside potential or volatility. We then use sophisticated investment planning tools to build scenarios that reflect each client's unique financial situation and needs over time to evaluate which asset allocations have the highest probability of meeting each client's financial objectives.