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The fall of 2018 marks a decade since the darkest days of the Financial Crisis of 2007-09, and investors remain justifiably scarred by the calamity. The passage of time, however, offers the opportunity to assess what went wrong and how to avoid repeating past mistakes.
Intelligent, rational investors made some missteps prior to the crisis that resulted in significant losses of wealth. Many of the missteps are a result of popular misconceptions regarding major market events, diversification, and risk.
Unfortunately, many years later, these misconceptions still lay at the foundation of portfolio construction and expectations.
Identifying and understanding these misconceptions can help redefine portfolio construction and risk management, so investors can be better prepared for the next major market event.
The challenges facing investors entering retirement are vast:
• Diminished role of public and private pensions and the greater importance defined contribution and IRA plans
• Increased longevity risk
• Bond yields at historic lows, threatening both the income and capital preservation roles of fixed income
• U.S. equity markets at all-time highs while the global economy is slowing
• Sequence of returns risk
• Behavioral finance/emotional risks
We look at tackling this ‘Gordian Knot’ of challenges that might appear insurmountable.
There are a lot of misconceptions amongst investors as it relates to equity investment returns, hedged equity returns, and the math behind them. However, understanding the core mathematical principles driving investment returns can help investors make better investment decisions.
These core principles are often overlooked, ignored, or misunderstood by investors and will be explored in this paper for the purpose of strengthening the decision-making process.
1. The importance and power of compounding
2. The value of avoiding large losses
3. The importance of variance drain
4. The importance of a non-normal distribution of returns