- Markets are not governed by rules of law or nature, and so even very unlikely outcomes are possible.
- Investors should carefully consider the point at which they are likely to give into a panic-driven urge to sell.
- Managing your investments so as to keep them above a floor value is essential to prevent panic-driven decisions.
“Failure is temporary. Giving up is permanent.
– Billionaire Biotech Pioneer Kiran Mazumdar-Shaw.
I have four brothers. While we were quite close when we were kids, as you can probably imagine we got into more than a few scraps back in the day. When one of us had the upper hand on another, we would insist that the sibling who was in anguish throw in the towel by saying “uncle”, although I can assure you none of us had a clue why that particular idiom signaled submission. As it turns out, the expression can most likely be attributed to the Irish word “anocal”, which means an “act of protecting; deliverance; mercy, quarter, safety”.
Investors cry uncle when they sell stocks in a panic. As I discussed in an earlier post, it is critical for investors to structure their portfolios and to manage their investments in a manner that will keep them from crying uncle when a bear market sets in. When fear takes control, the desire to sell overwhelms rational thinking, and investments are sold with little regard to the sale price.
Sensible, rules-based and thoroughly backtested investment strategies can provide the confidence needed to stay the course during a bear market. However, backtests are backward looking and do not account for market movements that have not happened before. Monte Carlo simulations (computerized mathematical models that calculate the probability of an outcome over a range of randomly selected values) can overcome some of the limitations of backtests, but the variables used in the simulations are normally based on history. As a result, investment strategies typically do not account for events that have not happened before.
For example, while the longest U.S. bear market lasted 21 months (from January 1973 till November 1974), there is no irrefutable rule to prevent a bear market from lasting much longer than that. (The ongoing Japanese bear market began in 1989!) As Nick Maggiulli explains in his recent post, markets are not governed by laws, only tendencies. Consequently, investors can never be entirely certain of what comes next. It is this uncertainty that can cause investors to lose their nerve during a stock market crash.
Panic driven decision-making in bear markets can be avoided by (i) determining how low the value of your portfolio can fall before you freak out and make bad decisions (I refer to this value as your “Floor Value”); and (ii) adopting an investment strategy that makes it extremely unlikely that the value of your portfolio will fall through the Value Floor you have set, regardless of what the future holds.
Determining your Floor Value is not easy. If you are saving for your retirement, the question that needs answering might be: “What is the least amount of risk I can assume and still expect to generate the returns I need when I retire?” For others, whose investments are already worth more than they will ever need for their support, the question might boil down to: “How much risk can I take without jeopardizing my current standard of living?”
If you work with an investment advisor, he or she should be able to help you determine your Floor Value. Risk tolerance questionnaires can help, but are far from definitive. Moreover, your pain threshold will change as your circumstances and perspective change, so you ought to revisit this question annually.
Once you have determined your Floor Value, the next step is to do your best to determine the likelihood that the value of your portfolio will remain above it. Perhaps the simplest way to make sure the value of your investments stays above your Floor Value is to ensure the value of your risk-free investments (such as government bonds and cash equivalents) is always greater than the floor amount. Another is to use tactical asset allocation strategies that reduce the amount of drawdown during bear markets. A third is to purchase option contracts that provide protection against bear markets.
There are different ways to forecast the likelihood of a portfolio remaining above a specified value over a given time period. One of the most recognized is Value at Risk, or VaR. VaR is a statistical calculation of the probability that the value of a portfolio will fall to a specified amount over a certain time period interval. Monte Carlo simulations can be very useful when calculating VaR.
Of course, when it comes to investing there is no free lunch. Lowering risk – whether that is a result of adopting a higher Floor Value, targeting a higher degree of confidence you will not fall through your Floor Value, or a combination of the two – will inevitably lower expected future returns. There is a price to pay for piece of mind. However, the price of making a bad decision when panic strikes can be much greater.
Many investors throw in the towel on their portfolios when panic strikes. Others, such as Dr. Michael Burry, John Paulson and Warren Buffett, made fortunes by capitalizing on investors’ fear-driven decisions. Similarly, in the 1995 movie “Ace Ventura: When Nature Calls” Jim Carey wisely kept his cool when he was attacked by an alligator. Unfortunately for the alligator, it wasn’t able to cry uncle.
Thank you for reading.
The Market Commentator