Since this is the first bull market during which I’ve been invested in the stock market, it’s been interesting observing my emotions as US stocks have marched steadily higher. My investments are completely passive and I don’t have any interest in acting on my emotions, but I understand where the impulse to react hourly or daily to market events comes from.
I don’t really care about the value of my investments, except that I’d like to buy them as cheaply as possible, but one thing that serious investors seem to obsess over is the magnitude of decreases in the value of their portfolio. Diversification, according to this logic, isn’t expected to increase your absolute returns, it’s expected to increase your “risk-adjusted” returns. In this logic, adding bonds to a portfolio doesn’t increase the return of the portfolio, it decreases the portfolio’s volatility.
Since the stock indices are regularly posting all-time highs, and publicly traded companies are trading at higher valuations than their historical averages, people obsessed with protecting their portfolio from decreases in value fret about the inevitable coming collapse in stock prices.
I am likewise certain there will be a sharp decrease in stock prices, I just don’t plan on doing anything about it.
The reason is simple: I know there will be a sharp drawdown in stock prices, but I don’t know what the starting point of the drawdown will be. I think there are two interesting ways to describe this problem.
If the selloff begins tomorrow, we know the starting point of the drawdown. Vanguard 500 Admiral Shares, my main investment, closed today at $217.34. That lets us calculate the post-drawdown low:
- a 10% drawdown would reduce the value to $195.61;
- a 20% drawdown would reduce the value to $173.87;
- a 50% drawdown would reduce the value to $108.67.
The interesting thing about these values is that we actually know the price history of the fund, and can easily determine the last time the fund traded at those prices (or slightly below, since it’s a mutual fund with prices calculated just once daily):
- VFIAX closed at $192.87 on November 4, 2016;
- VFIAX closed at $172.43 on February 12, 2016;
- VFIAX closed at $106.49 on October 7, 2011.
If you were certain that a 50% drawdown would start tomorrow, the obvious thing to do would be to sell everything, wait for the fund’s value to fall to $109 or so, then buy back in. You’d thereby double your share count and future income stream compared to the buy-and-hold status quo.
The historical data, I think, illustrates one problem with this logic. What if, on October 7, 2011, you knew there would be a 50% drawdown, but you didn’t know it would take until February 16, 2017, to arrive? You’d sell everything, thinking you were protecting your portfolio’s value from falling to $53.25, while in fact you were “protecting” yourself from 5 years of quarterly dividends and a share price sitting exactly where it was that morning!
I was joking about this question on Twitter the other day: “If the S&P 500 increases by 0.5% every trading day for the next 6 months, how long before it’s 20% lower than today?“
The point is, when deciding whether to buy or sell a security today, it’s essential to consider how future price increases protect you from from future price declines. A security that doubles in price is insured against a 50% drawdown, which would merely bring it down to a price that you already decided was worth paying.
People normally phrase this in reverse: “it only takes a 50% drawdown to wipe out a 100% gain.” But it’s equally true to say “a 100% gain protects you against a 50% drawdown.” Likewise a 25% gain protects you from a 20% drawdown and an 11.11% gain protects you from a 10% drawdown.
Look: if you know the date the drawdown begins and ends, you should sell the day before it begins and buy the day after it ends.
But if you only know, as I do, that there will be a massive drawdown at some point in the future, but you don’t know, as I don’t, when it will be, then selling off investments in anticipation of it is merely selling yourself out of a stream of dividend income.
If, on the other hand, you want to lock in your gains in order to start a business that’s more profitable than your current investment strategy, that’s a different story entirely.