Win by not losing. That may sound like a good plan for a Las Vegas weekend, but it also applies to investors who are in it for the long haul. Avoiding steep drawdowns is one way—some may argue the most important way—to help stay on course with long-term investment objectives.

The extreme volatility witnessed during the first half of the year may be an environment that astute active managers can use to their advantage to build positions in stocks they favor. But let’s be honest. Most investors don’t like those big price swings. In fact, when volatility returns and stocks pull back sharply, investors are quickly reminded that steep drawdowns can derail wealth creation goals, and that recouping losses may require a significant reversal and rally. Significant is the key word here.

Don’t take our word for it. This reality is rooted in simple math. The formula to calculate what percentage gain is needed to make up for a percentage loss looks like this:

Required Gain = [1 ÷ (1 – Percentage loss)] – 1

But forget the algebra for now. Rather, let’s simply remember this: When the price of a security declines, it requires a greater move higher on a percentage basis to recoup losses. The numbers might surprise you. A smaller 10% loss necessitates a slightly higher 11% gain to get back to even. This challenge intensifies as the losses get steeper. A 25% drawdown decline requires a bounce-back of more than 33% to recoup losses. And if you buy a stock or a fund that plummets by 50%, you now need a double (i.e. 100% rebound) to get back to even. The following chart spells it out.  

Downside Protection—It’s Not a Fad

During the first half of this year, the markets have been driven by newsflow and defined by extreme volatility. Tariffs are on—tariffs are off. Rate cuts are imminent—the Fed is in no hurry. Inflation is licked, but maybe it’s back. We are careening toward recession; wait, it’s just a mild slowdown. All this uncertainty has whipsawed investors and, unsurprisingly, brought risk management back to the forefront of investor consciousness. However, we believe that downside protection should be front and center in all environments and at all points of the business cycle, not just times when risk is off.

Nevertheless, given that many investors are once again keenly focused on risk, we thought it might be useful to share a few of our downside protection tenets:

1. Always consider what can go wrong first. For our team, that means adhering to our valuation principles and buying as close as possible to the downside price target. It can also mean avoiding companies with excess leverage and high debt service burdens in favor of companies with strong underlying franchise and asset values.
2.  Start with the balance sheet. Rather than concentrate on the income statement and near-term earnings, we suggest a deeper dive into a company’s balance sheet to better understand the health of its businesses. Focusing on the balance sheet and cash flows is a differentiated approach that may offer early-warning clues into financial improvement or decay, thus providing an important tool for downside protection.
3.  Focus on Return on Invested Capital (ROIC). Improving ROIC is the essential measure of the value-creating capability of a company, in our opinion. Investing in companies that are undergoing significant positive structural improvement in ROIC can have a profound impact on cash flows and earnings, which may allow companies an opportunity to improve financial performance irrespective of what is happening in the general economy, within the sector, or among competitors. Put differently, we think that buying companies with improving ROIC can outperform in up and down markets.

Time For Active Management?

It appears that we are in a new era of heightened uncertainty and volatility. No one can be sure how this might reshape global trade and impact economic growth. These are unknowable, to be blunt. But as active managers and stock pickers, we see market volatility as something to be embraced because it may obscure opportunities in individual securities. That can be a good thing. Heightened volatility, coupled with an unwavering commitment to downside protection, looks like it may be an effective formula in today’s unusual environment.