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Downside Protection

We are taught early in our financial education that Investing is all about the relationship between risk and reward:  What might you win? versus how much you might lose?  And at its core, this will always be true.  But the risks associated with the successful implementation of a financial plan are not so clear cut.  

Risks to achieving your financial goals come in many forms: How much are you saving on a periodic basis? How much are investment vehicles costing you?  Are your investments beating inflation?  What kind of tax liability is the activity in your account generating?  Are you mentally prepared to ‘ride the waves’ of high volatility asset classes like stocks?   

Naturally, the most visceral fear in investing is the potential loss of principal.  In portfolio management, downside protection describes the mitigation of investment losses.  In today’s educational blog post we’ll be discussing the needs and methods for successful downside protection.  

The need for downside protection arises separately from both mathematical and emotional necessity.  On the mathematical side, the need for downside protection is very straightforward.  For example, if you lose 50% of something, you’ll have to earn 100% to get back to where you started.  So, depending on where you start, one percent up is not the same as one percent down.

On the emotional front, the need for downside protection is a result of cognitive traits that humans have developed for survival.  The cross-section of these cognitive traits and the way we behave as investors is the domain of behavioral finance.  In this case, we’re discussing loss aversion.  

Loss aversion describes the tendency to be more sensitive to negative outcomes than positive outcomes.   For example, studies have shown that giving somebody a $5 bill, has a less positive emotional impact than the corresponding negative emotional impact of taking a $5 bill from them.   In investing, this tendency is the root cause for all kinds of irrational behaviors.  And it’s the main reason investors do things like abandon their investing strategy at precisely the worst time.

While there are many operational remedies that can provide downside protection, the two most important are: a) developing an investment strategy that is appropriately calibrated to your risk tolerance and financial goals and b) hiring an investment manager that can consistently deliver on the needs that your financial situation calls for.