Investment Losses – Do you need a market “shock absorber”?

Wow is 2020 off to a volatile start! It is quite possible that 2020 may be a down year overall or at least displaying increased volatility – It’s anyone’s guess what happens next.

Dow Jones – Losing 12%+ in one week

However, if we refer to our last post, we defined the different types of market risk, and as the conclusion we see that we can minimize the asset risk portion of this equation but not the overall global market risk portion.

So how do we actually do this – Minimize Asset Risk?

Let’s review the different types of assets that can be used for investments.

If you missed our last post on market risk, review it here.

Available Asset Classes

  • Stocks – Tiny ownership fractions of a company available for sale on markets (Stock Markets) that can be bought and sold by private individuals, groups, public entities, large institutions and others. Stocks are sold on the open market and represent ownership in a company. The value of these stocks fluctuates everyday based on market conditions; risk is highest.
  • Mutual Funds – A group of stocks, bonds, real estate – acts as a collection of the underlying asset and has a risk profile associated with the asset type (see stocks, bonds, real estate). These are typically sold as mutual funds (group of funds) or exchange traded funds (group of funds); risk of funds is the same as the underlying asset class or what they are invested in.
  • Bonds – The issuance of debt as a loan, with interest payment, by either a private company, government or another body. This asset class pays an interest payment and the face value (original value) of the bond; risk of bonds is lower then stocks but still risky based on the government or company that issued the bond.
  • Real Estate – The ownership of a physical property either by individual, government or company for use or investment. This asset class can pay “interest” in form or rental income and the value of real estate can fluctuate up or down depending on market conditions; risk of real estate is average due to economic conditions, location and type or value of property.

Now that we have a grasp on these assets, how can we manipulate them to reduce our overall volatility, improve potential returns and reduce asset risk?

Note: We will be using ETF index funds in our test samples here – Future article to follow on what ETF are and how to invest in them. Vanguard products are listed below as samples due to extremely low fees; feel free to use any comparable ETF in your personal analysis. We are not recommending any of these products below; educational use only, please do your own research and contact a certified financial professional before implementing anything.

Round #1 – 100% US Stocks

Total Stock Market Index = VTI (100%) vs Dow Jones Industrial Average

If we use a test sample case and apply the following stock biased allocation, we see the following results:

If we look into an ETF like Vanguard VTI, we see that it represents over 3566 companies vs the Dow Jones Industrial Average which represents only 30 stocks. Based on this, let’s see if buying 3500+ US stocks can reduce our volatility and improve our potential investment returns.

Based on the 1 and 2 year performance through back-testing below, we see an immediate improvement on total returns (including the downturn this past week), with matched volatility. Winner = VTI.

  • 1 Year = 6.9% VTI Yield vs 0.4% DIA Yield, equal volatility
  • 2 Year = 11.2% VTI Yield vs 4.7% DIA Yield, equal volatility

Round #2 – 50% US Stocks, 25% International , 25% Real Estate

Total Stock Market Index = VTI (50%) + VYMI (25%) + VNQ (25%) vs Dow Jones Industrial Average

If we use Test #2 above and apply the allocation, we see the following results:

If we look into an ETF like Vanguard VTI, we see that it represents over 3566 US companies, Vanguard VYMI which represents 969 international stocks and Vanguard VNQ which represents 185 real estate companies vs the Dow Jones Industrial Average which represents only 30 US stocks. Based on this, let’s see if buying 4700+ stocks can reduce our volatility and improve our potential investment returns.

Based on the 1 and 2 year performance through back-testing below, we see an immediate improvement on total returns (including the downturn this past week), with reduced volatility. Winner = VTI, VYMI, VNQ.

  • 1 Year = 4.5% Test #2 Yield vs 0.4% DIA Yield and lower volatility
  • 2 Year = 10.4% Test #2 Yield vs 4.7% DIA Yield and lower volatility

Round #3 – 25% US Stocks, 25% International , 25% Real Estate, 25% Bonds

Total Stock Market Index = VTI (25%) + VYMI (25%) + VNQ (25%) + BND (25%) vs Dow Jones Industrial Average

If we use Test #3 above and apply the allocation, we see the following results:

If we look into an ETF like Vanguard VTI, we see that it represents over 3566 US companies, Vanguard VYMI which represents 969 international stocks and Vanguard VNQ which represents 185 real estate companies and Vanguard BND which represents 9132 bonds vs the Dow Jones Industrial Average which represents only 30 US stocks. Based on this, let’s see if buying 13,000+ stocks and bonds can reduce our volatility and improve our potential investment returns.

Based on the 1 and 2 year performance through back-testing below, we see an immediate improvement on total returns (including the downturn this past week), with reduced volatility. Winner = VTI, VYMI, VNQ, BND.

  • 1 Year = 5.7% Test #2 Yield vs 0.4% DIA Yield and even lower volatility
  • 2 Year = 11.5% Test #2 Yield vs 4.7% DIA Yield and even lower volatility

Conclusion:

If we review this data, we see that adding additional types of investment or even more diversity of the same investment class can rapidly improve our chances of improving returns while simultaneously reducing volatility; winning on all fronts – Effectively, adding a shock absorber to your investing portfolio.

Therefore, please use this exercise to develop your own asset allocation strategies and work to improve your chances of great returns over time.

By adding differing types of asset classes like our round 3 example of 13,000+ stocks and bonds – greatly improved the sample volatility and improved our potential investment returns. Based on the 1 and 2 year performance through back-testing, we saw an immediate improvement on total returns (including the downturn this past week), with reduced volatility. Winner = VTI, VYMI, VNQ, BND.

  • 1 Year = 5.7% Test #2 Yield vs 0.4% DIA Yield and even lower volatility
  • 2 Year = 11.5% Test #2 Yield vs 4.7% DIA Yield and even lower volatility

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13 thoughts on “Investment Losses – Do you need a market “shock absorber”?

  1. […] SAVING / INVESTING – If you have substantial income bearing savings in the banking sector, what should you do – If you have a longer time-frame horizon with locked in GIC rates above today’s rates, probably best to leave this money alone for the time being. If you have renewal pending in the next few weeks or months, its time to look into options – Guarantee your returns through another GIC or savings account renewal or look into tucking some of this money back into the stock market through ETF investments that currently offer significant discount pricing – See our other posting about a Market Shock Absorber when investing. […]

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