Investors are quite skittish these days. 2001-2002 was bad enough, but then 2008 came along. Most investors lost a boatload of money, in some cases enough to get them to swear off investing altogether. Although that may be understandable from a certain perspective, it’s probably not the way to go. The reality is that market volatility is to be expected. Charlie Munger, Warren Buffett’s investing partner at Berkshire Hathaway, rather unsympathetically expounds on what investors should expect (my emphasis added):
“I think it’s in the nature of long term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”
I’ve seen plenty of people react to a 50% decline, but not usually with equanimity! The always excellent Psy-Fi blog has this further comment:
Munger is, as usual, spot on the money. It turns out that the odds of a 50% drawdown in any investor’s portfolio during an investing lifetime are virtually 100%. Dabble in stocks for long enough and you’re bound to lose half your net worth in a single swoop. In some recent research Guofu Zhou and Yingzi Zhu have set about demolishing the idea that our most recent set of calamities are surprising.
In other words, what markets are going through right now-although it’s clearly the unpleasant part-is just part of the normal cycle of investing. The problems come when investors create drama over what should be expected. It might be healthier to imagine one’s portfolio as having a wide range of possible values, as opposed to taking mental ownership of the equity value reflected on your best monthly statement. Psy-Fi has a couple of suggestions for reducing the unnecessary drama:
…intelligent investors should mange their holdings with the expectations that they’ll lose 50% of their value at some point. The main aim should be to ensure that such a drawdown is a temporary measure and, if you’re invested in good enough stocks, this should surely prove to be the case over a few years. This is the lesson of behavioural finance: be humble in the face of the markets, diversify wisely and don’t use leverage.
That’s a pretty good prescription: 1) think long term, 2) diversify effectively between strategies, and 3) don’t use leverage. Patience always helps, because drawdowns in most sound strategies are temporary. Diversification between strategies (not necessarily just asset classes) can help mitigate drawdowns too. We find, for example, that high relative strength strategies blend nicely with deep value strategies. Finally, the absence of leverage gives you the staying power to hold on during a drawdown. Too much borrowed money, as some overleveraged homeowners are finding out, will cause you to mail in the key to your portfolio to the margin clerk at an inopportune time.
Investing is a rough game; you’ve got to be tough to play. To paraphrase Yogi Berra, “Investing is 90% mental, the other half is rational.”
