No Need For A Drawdown Drama

Whenever markets go into free-fall we see a certain drama play out: participants firstly refuse to believe things are going wrong, then gradually subside into confusion before eventually capitulating and demanding that something needs to be done and that someone's to blame. Generally, of course, the people most to blame are the ones in the mirror in the morning who've either let greed get in the way of good sense or fear in the way of opportunity. Sadly these people are obviously getting out too much and not spending their evenings studying the statistical lessons of stockmarket history. What these tell us is that although we can have no idea how markets will next go loopy we can guarantee that they will. And every year that they don't just makes the slippery slope that much steeper.

Myopic Greater Fools

If you start from the point that markets are inherently unstable and that they're likely to drop suddenly, sometimes for no apparent reason, then you'll hopefully adopt an investing strategy that reflects this. The people who mainly get damaged when markets collapse are those invested in rubbish or over-leveraged or simply unable to manage their own emotions. Finding all three together's not uncommon.

There seem to be a couple of things going on here. Firstly there's disaster myopia, where people don't think that a problem will ever occur, and secondly there's the problem of the Greater Fool where people think that they can get out before any crisis. So how inevitable are market falls?

Munger Speaks

In a recent interview Charlie Munger stated:

"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."

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.

Greenspan Speaks

Generally speaking most investors seem to regard the recent market falls as the work of the devil or, as he's more popularly known these days, Alan Greenspan. Greenspan himself has called the market falls a "once-in-a-century event" but old as the ex-Chairman of the Fed is it seems he's not ancient enough. To be fair, the words probably imply that such events are rare, rather than an implicit hundred year long cycle. Anyway, Zhou and Zhu's results confirm the venerable Greenspan's intuition – based on their simulations the probability of a 50% drawdown in markets over a hundred year period are 100%. So was it just bad luck that it happened while we were investing?

Waiting for Swanee

The researchers then used their results to calculate the accumulative probability of a so-called Black Swan event in any given year. They assume that there's a 1% chance of a nasty 50% drawdown in any given year (the one in a hundred year event) and then further assume that in every year there's no nastiness the probability of something evil lurking in the markets grows. This seems intuitively correct: the lessons of disaster myopia tell us that with every passing year of placid conditions people get a little more confident, use leverage a little more and generally take on a bit more risk.

With these two assumptions in hand they then calculate the growing probability of a crisis in any given generation. It turns out that as we approach the twenty year mark the probability of a crash tends to 1: each successive year merely makes it more certain. Even worse, the longer the markets go without a psychologically chastening reversal the larger the potential losses grow as risk appetite soars. So 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. So what do people actually do?

Illusory Stocks

Well mostly they play the Greater Fool and don't expect markets to collapse until they're ready for them. Markets, sadly, rarely play ball. The illusory values of rising markets fool all too many investors all too often. On the upswing many stocks get pushed to unwarranted highs simply through weight of money. A share price at any given time is simply a snapshot of a popularity poll, not a statement of intrinsic worth. So when there's more money about there are also more votes available and some of those will go to those lunatic parties that lie on the fringes of society.

A trivial thought experiment can show why weaker companies appear to do better during economic upturns. Imagine two companies in the same industry with radically different profit margins – 1% and 5%, say. All things being equal the latter is the better company because they can make more money for the same selling price. During the good times where there's excess demand over supply both companies may be able to increase their prices and profit margins by the same amount. If they can both increase prices by 1% without affecting costs then the profit margins will move to 2% and 6%. Note that the weaker company has doubled earnings while the stronger one has improved by only 20%.

This illusion leads investors to prefer weaker companies to stronger ones as they project growth rates to infinity and beyond. So, often the votes go to the weaker companies over the stronger ones, a result which can be intensely damaging to eventual returns when the inevitable downturn comes.

Naïve Bubbles

Research summarised by Porter and Smith in Stock Market Bubbles in the Laboratory shows that ensuring people understand the fundamental value of their investments doesn't stop bubbles forming and popping. In fact, only personal experience – twice over – has this effect and only then when the group of people suffer the same experiences. Perhaps most interestingly when market participants are overwhelmingly inexperienced the bubble forming forces are unstoppable by experienced and rational traders, who run out of selling power and are unable to push prices down.

Overall, the experimenters comment "bubbles seem to be due to uncertainty about the behavior of others, not to uncertainty about dividends".

Do tell.

Of course, this is all laboratory based and probably doesn't flow naturally over to the real-world, but it seems to mimic what we see in markets enough to at least raise a few eyebrows. It's human psychology that makes these 50% drawdowns inevitable and the twenty year cycle seems to be just enough for markets to forget the last crash and to allow risk management standards to slip.

Be Humble

Understanding that market falls of 50%, or more, are normal – if rare – is an important element of a strong investor's psyche. Unfortunately many understand this without understanding the corollary: when markets collapse weak companies get hammered. Anyone who truly believes in the overwhelming probability of major market falls won't go near ephemeral businesses with illusory business models. Nor will they gear up to invest in risky markets. No, they'll learn the proper lessons of history. Be humble, be careful and, above all, be prepared. Investing in stockmarkets may sometimes resemble a soap opera but we should never need to make a drama out of a crisis.