Dr. Myron Scholes argues that focusing on relative risk, rather than the impact of total risk on compound return, is like using only one hand to clap.

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The investor wants to maximize the compound return of their investment to get the best terminal wealth and they’re interested in how much drawdown they have to take to achieve that terminal wealth objective. The problem with indexing, or the problem with passive investments and/or active investments, in some sense, it’s all based on the jargon alpha, it’s all based on how well you do relative to the benchmark. The important thing about managing money is total risk, it’s not relative risk. It’s how your portfolio is doing and what causes the risk of your portfolio to change, and if you don’t incorporate thinking about how risk changes, and how that will, risk changes will impact on the compound return, then investment management is only using one hand clapping, it’s not using both hands clapping. And my view is that risk management is much more important, much more important than deciding how much active or how much passive investment to hold, because at times of shock in the market when uncertainty increases it’s very hard to tell the difference between a passive investment manager and an active investment manager. They’re very, very highly correlated with each other. In managing money, the debate should be how to manage the risk of the benchmark.

If you’re just holding the index, you know it dropped 50% in 2007-08, and it dropped 50% or 55% in 2001, you know, and you could drop 20% or 15%. And if you’re interested in compound return and not average return, those hurt. Those big drawdowns hurt. And they hurt the investor because once you suffer a large drawdown it takes a long time to recover, you know. And the interesting part of investments is that it’s the large drawdowns, or experiencing a large drawdown or missing a large upside, that have the greatest effect on investors’ terminal wealth. Investors are interested in terminal wealth. They’re interested in how well can I accumulate, or what can I do over time because my terminal wealth gives me money to consume. It gives me money to consume to send my kids to school, or gives me money to consume to take a vacation, buy a house, retirement, medical, etc. And those are very important to investors. And we’re tending, if we concentrate on relative performance, we miss what the investor really wants. The investor really wants a growth of their portfolio but worried about how much downside I’m going to take. Why are you worried about downside? The investors are worried about downside because they might need to consume, or they don’t have money. Or they might want to retire sooner. If they take the drawdown they’re going to have to retire later in life, and those are very important considerations. It’s the drawdown which is the most important risk.

And the interesting part about compound return is that every period matters. You can’t say as an investor that you’ll have a long horizon, like I’m going to be invested for 10 years, because if you start and you say you’re going to be invested for 10 years, if in the first year you lose 90%, it’s going to take a very long time to catch up, maybe never.

Investment is not averages. Investment is compounding. And what I mean by averages is, average returns assume that we’re always investing the same each period. So if we start off with 100, we invest 100 today, we make money, we take the winnings out, consume it. If we lose money we put that back in and we’re always investing 100 each period. Compound return, on the other hand, accumulates, it takes the money, the 100 an investor has today, and if they make 10% it’s now 110.

It’s always accumulation until such time as one wants to convert that to consumption. And so basic compound return, the mathematics of compound return, are much different from average return, because average is simple. You just take the sum and you divide by how many units you had, and you just divide, and you assume distributions.

If we look at the returns from 1857 to the end of 2016, we found that if one invested a dollar at the 1857, held their portfolio through to current time, that that one dollar would compound at about 5% a year. So one dollar would grow to over $3,000 over that period of time. But if one were fortunate and you sold all your stocks for the worst of the performing months over that period of time, then your compound return, instead of being 5%, would be 9%. So avoiding the worst months, you end up with a 9% return, which means instead of your dollar growing to $3,000, it grows to $1,400,000 over that period. And what, on the other hand, if you sell all your stocks off for the best months in the market, instead of your compound return being 5%, it would only be 1%.  One dollar grows to $8 over that period of time. What this illustrates to me is that the lion’s share of returns are determined not by the little ups and downs that you have each period of time, but by the tails of the distribution. In other words, participating in the gains is important, avoiding the losses are important. They have the largest effect.

For the period 1/1/1857 – 12/31/1925, individual security returns were gathered from U.S. financial periodicals on a monthly basis, beginning with the official list of the New York Stock Exchange during that time period. From the period 1/1/1926 – 12/31/16 returns are represented by the S&P 500 Index. Source: Ibbotson. Past performance is no guarantee of future results. Assumes reinvestment of income and no transaction costs or taxes. This data is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. An extreme tail gain or loss is described as any monthly period whose performance is 2 standard deviations above or below the average monthly return for the entire period. 

Again, it’s not focusing on the average because the average tries to wash away the tails. It wants to trace what’s the average experience.  But, the average experience is not what we live. In our world we don’t live the averages, the tails affect everything we do. And if you look at the data, the number of big tails are much larger; the tail results are much larger than would be anticipated by a normal distribution. Many more observations that we had, many more monthly returns, or quarterly returns fall greater than what we predicted in the tails. So the number of bad outcomes far exceeds what you would expect in a normal distribution.

For the period 1/1/1857 – 12/31/1925, individual security returns were gathered from U.S. financial periodicals on a monthly basis, beginning with the official list of the New York Stock Exchange during that time period. From the period 1/1/1926 – 12/31/16 returns are represented by the S&P 500 Index. Source: Ibbotson, based on monthly returns.

Assumes reinvestment of income and no transaction costs or taxes.

An extreme tail gain or loss is described as any monthly period whose performance is 2 standard deviations above or below the average monthly return for the entire period.