The stock market is inherently volatile, and the high octane stocks are much more volatile than the market in general. The strongest long-term performers are many times the most volatile stocks in the short term.
The market is a powerful wealth creation mechanism, in order to benefit from this amazing machine, you need to be able to tolerate volatility. Even better, volatility can be actively managed and even embraced for its long-term benefits in terms of future returns.
There are 3 main points to consider:
1. Understand that volatility is normal.
2. Understand that more volatility today means higher returns in the future.
3. Have practical strategies to manage your volatility exposure and to deal with the volatility that you have decided to accept.
What if you had a time machine allowing you to travel back in time and buy only the stocks with the biggest future returns over the next 5 years?
That would be nice to have, right?
In that case, you would know exactly which stocks have the best future returns and you would make enormous returns from your investments.
However, the surprising part of the equation is that you would still have to endure big drawdowns and several periods of underperforming the indexes by a wide margin.
Wesley Gray, from Alpha Architect, published an extraordinary article showing how even the best possible investment strategy, one managed by God himself with perfect foresight, would go through massive drawdowns in the short term. This means that many investors would probably abandon such a strategy or even fire their asset manager.
If someone had perfect information about future returns, then this God-like asset manager would obviously buy only the best stocks in the market. This means that God would produce an outstanding average annual return of 29.37% over the long term.
However, returns are not risk-free. The chart below shows the different drawdowns that this portfolio would suffer over the decades. There are 10 different drawdowns of more than 20%, the biggest drawdown is 75.94% and in the 2008-2009 Financial Crisis the portfolio would lose as much as 40.75%.
The author concludes:
Our bottom line result is that perfect foresight has great returns, but gut-wrenching drawdowns. In other words, an active manager who was clairvoyant (i.e. “God”),(1) and knew ahead of time exactly which stocks were going to be long-term winners and long-term losers, would likely get fired many times over if they were managing other people’s money.
The book entitled 100 Baggers: Stocks That Return 100-to-1 and How To Find Them, by Christopher Mayer, can be an enormously valuable resource to understand how this works.
The book basically analyzes the stocks that have delivered the biggest gains by multiplying by 100X over the long term. Needless to say, a single stock with these kinds of returns can actually change your life financially.
However, when you look at the stocks that actually delivered those returns in the past, all of them had massive drawdowns along the way. All of them declined by 50% or more at one time, and in some cases they declined much more than that.
The article entitled The Agony of High Returns, by Morgan Housel, looks at the biggest gainers in the market from 1995 to 2015, and it reaches the same conclusion.
From the article:
It’s hard to grasp how the best-performing stock of the last 20 years could spend the majority of that time with returns that would make you want to vomit. It’s easy to think that the single-best investment to own is one that would make us smile every morning we woke up owning it.
But it wasn’t. It never is. And it never will be. That’s the nature of the stock market. On the way to making serious money, you spend a lot of time losing serious money. It’s a reality anyone investing in stocks, no matter what you own, has to face.
I looked at the 10 best stocks to own over the past 20 years. These are all cherry-picked for their stellar returns, and the stocks you would probably choose to own if you had a time machine. On average they increased more than 28,000%.
But they all spent a majority of the time well below their previous high mark. They all had multiple declines of 50% or more. A few had multiple 70% drops.
In simple terms, volatility is normal and unavoidable if you want to achieve superior returns over the long term.
Volatility is painful and hard to endure. But current volatility is also the passport to superior returns in the future.
If you have cash in the portfolio or cash coming in regularly, then volatility can actually increase your returns over the long term.
In this scenario, you can use your cash to buy at lower prices over time, and this makes a massive positive difference in performance.
An article from Nick Magully shows that dollar-cost averaging – DCA – which means regularly adding money and buying stocks over time, can be superior to a Buy the Dip strategy that only buys at market bottoms.
In this work, the author assumes that the Buy The Dip investor knows exactly when the market has bottomed, so this investor only buys at the exact lows. Again, buying regularly – DCA – produces superior returns versus buying only at dips.
In periods when market dips are very profound, buying the dip outperforms DCA. But remember that this is an unrealistic example that assumes that you can buy exactly at the precise bottom, so a strategy such as this one cannot be implemented in real life. Regardless, for long periods of time, buying regularly is generally superior to buying solely at market bottoms.
From the article:
My point in all of this is that Buy the Dip, even with perfect information, typically underperforms DCA. So if you attempt to build up cash and buy at the next bottom, you will likely be worse off than if you had bought every month. Why? Because while you wait for the next dip, the market is likely to keep rising and leave you behind.
I never buy or hold stocks in the Data Driven Portfolio unless I think that they can double or triple over the next five years. I don’t use price targets, but I just try to understand if the stock has this kind of potential.
If the stock doubles in five years, that is an annual return of 15%, and if it triples it is an annual return of 25%. These are only projections and subject to a large margin of error, of course.
Let’s say that you buy a stock at $100 with the expectation that it will go to $200 in the next five years. Even if you are right about those projections, the trajectory of prices is impossible to predict. Let’s assume that the stock then falls to $70 due to a pandemic, interest rate fears, or some other factor.
If the long-term thesis has not changed and the $200 target is still achievable, then from a $70 price your expected compounded annual is now 23% versus 15% originally. The lower the price goes due to current volatility, the bigger the upside potential in the years ahead.
Again, current volatility increases future returns. This is easy to see in the numbers, and the historical evidence confirms that this is in fact the case. If you have cash in your portfolio or cash regularly coming in, more volatility today means higher returns in the years ahead.
We know that volatility is normal and necessary, and we also know that current volatility increases future returns. But it is still hard to deal with volatility in everyday life, especially from an emotional perspective.
Let’s take a look at some practical tools to manage volatility and to deal with the volatility levels that we have decided to assume.
Managing Volatility With Cash And Diversification
In the Data Driven Portfolio I generally keep a sizable cash balance to buffer the volatility and also to make sure that I can capitalize on opportunities when stock prices have sharp declines.
In a strong bull market, this cash is going to reduce my upside, but I don’t worry much about that, because high-octane stocks can perform very well when the trend is bullish. In 2020, for example, the portfolio widely outperformed the market in spite of a large cash balance.
Recently, I have diversified a little bit into energy and financials too. This can also reduce the market rotation risk, and I can eventually sell these positions to buy more growth stocks if the market provides an opportunity to buy world-class stocks at bargain prices.
When the market is in a strong downtrend I can also consider hedging with inverse ETFs or other more sophisticated strategies. However, we need to be careful with this approach because it is hard to get the timing right in hedging. Besides, when the selloff is focused on a specific group of stocks, trying to hedge with an inverse index ETF can do more harm than good.
For most investors, the positions in the Data Driven Portfolio should be only part of a more diversified investment strategy. How to manage this exposure depends very much on your own risk tolerance level and time horizon, and I can’t provide specific guidance. However, some ideas may help.
Let’s say that your time horizon is 5 years and you have a moderate risk tolerance level. An approximate approach would be putting 20% of your portfolio in high volatility Data Driven Portfolio stocks, another 40% in safer stocks and ETFs, and the remaining 40% in low-risk bonds and cash.
On the other hand, if you are a young investor with several decades until retirement and you like volatility, it is not unreasonable to have 50% of your portfolio allocated to DDP stocks. Especially if you are saving money regularly, so you know that you will have enough cash to buy on dips over time.
Again, these are just some very rough guidelines to explain the reasoning, everyone has different needs and variables to consider. But the point is that you can manage your risk exposure with both cash holdings and diversification across a wide variety of investments with different risk profiles.
There are also other alternatives such as using stops or hedging your positions with options. If you use stops for protection, you have to assume that there is a big chance that the stop will take you out of the position, and perhaps the stock will go higher after taking you out. That is the main disadvantage of this strategy, especially when you are dealing with high-quality stocks that tend to appreciate over the long term.
But stops can be very valuable to many investors, and there are many ways to achieve solid returns in the stock market. If you get taken out by a stop, you can always buy the stock again when the price action improves, or you can rotate into other names that you like more. In some cases, taking small losses quickly and buying other stocks with bigger long-term potential can have some important tax benefits too.
Should You Use Stops Or Not?
This is a very personal decision to make and only you can answer that question. The first thing that you have to decide is if you are going to hold a stock for the long term or manage the risk over the short term.
If you are a long-term investor, this means that you are planning to hold the stock for at least 3 years and ideally more than 5 years. As long as the fundamentals remain strong, price declines are buying opportunities and not a reason to sell. Using stops does not make much sense in this case.
If you are a more tactical trader, then using stops is of utmost importance. You should have your stops well in place and respect them, no matter what.
Personally, I like to hold the Top Priority positions for the long term and manage risk more actively in the High Priority and Tactical position. This is a mixed approach that works well for me, you should always do what works better for you based on your own timeframe, risk tolerance, and personality.
If you don’t have a personality, the first step is getting one.
Joking aside, ‘Know Thyself’ was carved into stone at the entrance to Apollo’s temple at Delphi in Greece. You have to understand who you are and what you want from your investments in order to understand if you should use stops or not.
It is very important to make this decision by truly understanding the trade-offs in using trailing stops.
You should also consider taxes and other factors such as how much cash you have in the portfolio, position size, and so forth. It doesn’t have to be all or nothing, you can use a stop on half of your position size or only in your riskiest stocks or the stocks in which you have less conviction.
There is no right or wrong here, the most important thing is finding the right strategy for you, making a conscious decision in advance, and accepting the good and bad things that can come with each approach.
Focus On The Long Term
For most investors, if you have cash and you have time, buying the dips with a long term horizon is probably the best way to maximize returns, even if this carries substantial volatility. This excellent chart from Charlie Bilello shows the chances of positive returns in the S&P 500 for different holding periods.
The longer your time horizon, the higher the chances of positive returns. Time is clearly on our side here, especially if you own high-quality stocks.
Now, if you have decided that you already want to hold a position for the long term, the best thing to do is to focus your attention on the long term and not stress too much about short-term volatility. If you are trying to eat a healthy diet, you should not be spending your day looking at a piece of chocolate cake, because that is going to make it harder to achieve your goals.
If you are planning to hold a stock for five years, you have much better things to do than looking at the price movements every five minutes.
Try to think about current price movements in perspective. What are we going to say about the recent decline five or ten years from now?
We may not even remember it, and there is a good chance that we are going to say that it was a big opportunity to buy high-quality growth stocks with a long-term horizon.
There is no need to suffer unnecessarily. If you have already decided that you will hold on to the stock as long as the fundamentals don’t change, there is no need to be looking at intraday price fluctuations. Most of that is pure noise, always.
Source: Behaviour Gap
I have a little secret to tell you, even if you stare at stock prices very strongly, those prices are not going to move in your direction, so you may as well spend your time doing something more productive.
There is a little trick that I like to implement when the market is selling off hard. In those environments, I place unrealistically low buy limit orders for my favorite stocks. I don’t expect those orders to get filled, and they generally don’t get filled.
These are just marginally small orders. The main idea is that if any of these orders get filled, it will trigger the notification, and I will consider buying different stocks in large quantities because prices are reaching opportunistic levels.
This little trick can help to put things in perspective. As prices start coming down sharply, you realize that this volatility can be a massive opportunity if your order gets filled, making it is easier to keep a long-term mindset.
Volatility is normal in the market, the most profitable stocks and the most profitable investment strategies tend to be particularly volatile. Even better, volatility today creates the conditions for higher returns in the years ahead.
You don’t need to assume more volatility than you are comfortable with. Volatility can be managed with cash, diversification, and also more active methods such as stops if you want to use them.
When you decide to reduce the volatility in your portfolio, there is a good chance that you will be reducing upside potential too, but there is nothing wrong with doing that. The most important thing is having a strategy and a volatility level that works well for you based on your own needs as an investor.
Once you have decided how much volatility you want to assume, a long-term perspective can make volatility much more tolerable and easier to accept