Volatility: how to tolerate it, manage it, and benefit from it (Ft: Financially Savvy)
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Announcement
Today’s issue is brought to you by my good friend Financially Savvy (@FiSavvy). A finance expert with a passion for investing/budgeting striving to help you make your 9-5 optional. In todays issue, we talk about volatility, how you can tolerate it, manage it, and even benefit from it. Judging by how the market has performed the past couple of months, you won’t want to miss this. Keep reading below and share it with your friends to save their portfolios as well!
Without further ado…
Volatility – Tolerating it, Managing it & Benefiting from it (Pt 1)
As we know, the stock market is inherently volatile and high-octane growth stocks are much more volatile than the market generally. But did you know that the strongest long-term performers are often the most volatile stocks in the short term.
The whole reason I started my Twitter account and Private Stock Group was to demonstrate how powerful the stock market is as a wealth building tool.
But, in order to benefit from this amazing machine, you need to be able to roll with the volatility! Additionally, volatility can be actively managed and even embraced for its long-term benefits in terms of future returns.
To achieve this, here are 3 things you need to understand:
Volatility is normal
More volatility today generally means higher returns in the future
You need practical strategies to manage your volatility exposure and to deal with the volatility that you have decided to take on
It’s necessary & unavoidable.
Imagine you have a time machine, allowing you to travel back in time and buy the best performing stocks over the last 5 years.
Pretty cool, right?!
Well, assuming this was possible, you would know exactly which stocks have the best future returns and you would make a killing.
However, what you might not realize is that you would still have to endure massive drawdowns and several periods of underperforming indexes by a wide margin.
Really give that some thought… This is the short-term cost of long-term growth investing.
But ‘Zoom out’, as they say…
Well, a chap from Alpha Architect, Wesley Gray published an awesome article showing exactly what would happen if you did this. It shows how even the best possible investment strategies, one overseen by God himself, with perfect foresight, would go through huge dips in the short term.
For those without the benefit of foresight, this would probably be enough to make them abandon such a strategy, or even fire their asset manager!
With all the information about future returns, 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 table below shows the different drawdowns that this portfolio would suffer over the decades.
Here are some key takeaways from this data:
- There are 10 different drawdowns of more than 20%
- The biggest drawdown is 75.94%
- During the 2008-2009 Financial Crisis, the portfolio would lose as much as 40.75%
Wesley concludes:
Our bottom-line result is that perfect foresight has great returns, but also gut-wrenching drawdowns. In otherwords, an active manager who was clairvoyant (i.e. “God”) 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.
There is a fantastic resource for the bookworms out there, “100 baggers: Stocks that return 100-to-1 and how to find them” by Christopher Mayer is an awesome resource to understand how & why this works.
Christopher analyzes the stocks that have delivered the biggest gains, multiplying by 100X over the long term. It goes without saying that a stock with these kinds of returns can be life changing if you hold enough of it early on!
The problem though is that when you look at the stocks that delivered those returns in the past, all of them had enormous drawdowns along the way. All of them declined by 50% or more at one time. And in some cases they declined by much more than that.
What stocks come to mind that you might hold over the long term?
Here are some of mine: $TSLA $PLTR $GEVO $CRSR $UPST $TWLO $SHOP
Well, an article titled ‘The Agony of High Returns’ by Morgan Housel, looked at the biggest gainers in the market from 1995 to 2015, and it reaches the same conclusion.
I quote:
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 are 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. More volatility today likely means better returns tomorrow. 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 increase your returns over the long term.
In this scenario, you can use your cash to buy at lower prices over time which 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 at specific intervals, can be superior to a Buy the Dip strategy that only buys at market bottoms.
In the article, 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 bottom, so a strategy such as this one cannot be implemented in real life because nobody actually knows where the bottom is.
Regardless, for long periods of time buying regularly is generally superior to buying solely at market bottoms.
A quote 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’ve never bought a stock that I didn’t think had the potential to either double or triple over the next 5 years. I don’t use price targets, I simply try to understand if the stock has the potential to multiply in value based on several simple factors.
If a stock doubles in 5 years, that’s an annual return of 15%. If it triples, that’s 25%. Obviously, these are just projections and subject to a big margin of error.
Example:
You buy a stock at $100 with the expectation that it will go to $200 in the next 5 years. Even if you are right about those projections, the trajectory of prices within that timeframe assumes that the stock can then fall to $70 due to a pandemic, interest rate fears, etc.
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.
Essentially, 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.
This is more true than any other time in my investing experience. We have stellar companies delivering brilliant results and growing revenues by 20%-30%+ each year which are now trading at pre-pandemic prices when those same companies were a fraction of the size.
The opportunity available to us, as long term growth investors is something that comes around maybe once in a generation.
The hard part is picking the right stocks. Obviously no one gets it right 100% of the time. But you don’t need to. Even with a 60% success rate, your winners will far outpace the losses from those duds you’ll wish you never bothered with.
How? Because you can only lose 100% of an investment. But there’s almost no limit to the upside potential if you pick right.
So, what should you do?
Focus on the fundamentals of the business and not the short-term price fluctuations.
If your stock drops 50% because of a severe bear market, but the fundamentals and thesis are intact, this is a huge opportunity to secure greater returns than you could have from your previous buy-in price.
I hope you’ve found this insightful, and thanks to The Dividend Dominator for letting me share this message with you today.
If you ever want to get in touch, you can DM me on Twitter @FiSavvy or @TheStockGroup
Have a great week!