Assume for a moment that you must pick one of two investment portfolios. The first one is a buy and hold approach where you get all the upside to return—and all of the downside—of the stock market. The second portfolio is built such that it often gets one-half of the upside and one-half of the downside. Which would you pick?

If you look at the buy and hold strategy over the past 20 years, a 100% stock allocation meant you were up over 120% over the period. In a secular bull market, buy and hold is the way to go. In a secular bear market, however, the second portfolio of half and half is optimal.

To illustrate, assume that the market drops by 40% and then recovers by surging 67%. An investor with $1,000 will decline to $600 and then recover to $1,000.

Sailing is analogous to the passive investment approach aka buy and hold. Rowing uses skill to limit the downside while accepting limits on the upside. When the stock market plunges, portfolios built by rowing generally experience only a fraction of the losses from sailing.

Half & Half

For the alternative approach, let’s divide the percentage moves in half and apply them to your portfolio: -23.6%, +50.7%, -28.4%, and +188.8%. Your initial investment of $1,000 declined to $764 in less than two years. With half of the market’s gains, your portfolio climbed to $1,152 five years later. Then, applying just half of the subsequent market decline, your gain sank to a loss of $825. Ouch!… again yields to a loss. Note, however, that while the market found its bottom below its 2002 trough, your portfolio is nicely above its previous dip. For now, accept that consolation prize.

Figure 1. Half & Half vs. The Market

Then, with just half of the market’s gains over the past 11 years, your portfolio again advances to new highs. Over the secular bear cycle-to-date, the market is up 120%, compounding at a modest 4.0% annually. Yet your portfolio is up 138%, providing almost 1.2 times the cumulative gain. With dividends and other income from your “rowing” portfolio, you have solid real (inflation-adjusted) returns.

HOW IT WORKS

Hedged portfolios outperform market portfolios in secular bear markets because of the disproportionate impact of losses relative to the gains required to recover losses. Most significantly, as the magnitude of the loss increases, the required recovery gain exponentially increases.

In secular bull markets, on the other hand, gains significantly overpower losses. So although cyclical swings deliver the occasional “correction,” the recoveries far exceed the losses. The result is that above-average returns from sailing cumulatively exceed those from hedged rowing. In secular bear markets, however, gains across the secular period are cumulatively fairly modest or nonexistent. The result is that losses during secular bears well overpower the gains. Hedge portfolios mitigate some of the negative effects and enable investors to succeed cumulatively.

Figure 2. The Impact of Losses

Figure 2 presents the dynamic of offsetting gains and losses. As the losses increase, the required gain to reach breakeven exponentially increases. To illustrate the half and half effect within hedged portfolios, note that the required gain for a 20% loss is 25% and the required gain for a 40% loss is 67%. Those two points are chosen because 20% is half of 40%, consistent with the earlier “half and half” illustrations. Note that you will see the same effect with 10% and 20% or with 30% and 60%, etc.

While the market investor needs 67% to recover from his 40% loss, the hedged investor only needs 25% to recover from one-half of the 40% loss (i.e., 20%). Yet when the hedged investor receives half of the market’s recovery, 33% from the near 67% surge, the hedged investor has exceeded the required 25% recovery return. As a result, the hedged investor achieves a net gain.