Through Thick and Thin – or Dealing with Downturns

We all know it’s easy to conceptualise a strategy over a long period but that it’s another thing all together to see it through in reality.  We investors tend to turn tail at the first sign of trouble and count ourselves lucky to escape with just our capital.  It’s only looking back later we realise the gains that may have been had we stuck to the plan.  Markets, after all, are said to transfer wealth from the impatient to the patient…so what can we do to help ourselves get on the right side of that old adage?

Patience and investing…

Joel Greenblatt, when asked why value investing works, famously once responded as follows:

1. Value investing works.
2. Value investing doesn’t always work.
3. Point 2 is part of the reason why point 1 is true.

He means that, in the long run, a true value strategy is more or less certain to make you money.  Buying dollars for 50 cents simply makes sense as a way to profit and if you are truly diligent in doing this, you can’t help but win…eventually.  Yet there are times when the madness of markets overpowers rationality and, despite your efforts to uncover discounted dollars, other investors just won’t pay up to take them off your hands.

These are the times when value investing doesn’t work, when people give in to consensus and take a hit just to get out of the game.  However, it is this very action that leaves those discounted dollars even cheaper than before, providing opportunity for the truly patient to make their profits.  And so the cycle continues.

Just how hard is it do this though?  It’s one thing to look at a chart in retrospect and think ‘ah, if I had spotted this stock 10 years ago, and held on through thick and thin, I’d have made 10 times my money!’  It is something else to recognise the opportunity in the first place, and something further still to recognise a continuing opportunity through the turbulent ride that any given decade brings in the markets.

An example…

How about an example to demonstrate this?  I have chosen A class Berkshire Hathaway shares as they have often been a classic buy-and-hold value/quality investors stock with a wonderful cumulative return chart looking like this:

One look at this and good old hindsight bias kicks in – ‘All I had to do was buy the stock in 1980 and do nothing and I’d be rich!’ We all know, of course, that it isn’t as easy as that but just how difficult is it?  At least part of the answer lies, I think, in analysing the drawdowns on the chart.  Just to be clear on the definition, a drawdown is in effect any time where the cumulative return falls below the maximum cumulative return to date.  You might realise from this that the stock is technically in drawdown most of the time, and I’m interested in exploring the psychological impact of this on someone attempting to buy and hold the stock for the full 35 years charted above.

To help I’ve created a graph showing the depth and frequency of drawdowns in the stock as follows:

This visually confirms our expectation that the stock is in drawdown for the majority of the time.  It makes sense after all – new highs don’t happen every day.  What really strikes me though is not just how much time is spent in drawdown, but the severity of said drawdowns.  The stock spends a huge amount of time down over 10% from recent highs and a fair bit down over 20% or more too.  Just to highlight that point, I’ve prepared a table of the worst 5 drawdowns to try and make them a little more tangible:

You can see that not only are there a number of severe drawdowns but that some of them really persist.  From December 2007 it took just over 5 years to return to a new high and in the meantime you saw the value of your holding cut in half.  So, how do these drawdowns impact us psychologically on the long road to riches?

Well, I think the availability bias combined with loss aversion tendencies play a significant role here.  The availability bias means we tend to place weight on recent information over old due to its availability, translating in this case to make us think of recent prices and recent highs as our level of wealth.  This makes sense – in 2006 we are hardly going to remember the initial investment we made 25 years ago, and will instead view our wealth (quite rightly) as the recent value of our holding.

This also means, however, that when 2007 comes around and we start to see prices fall, we will frame the fall in price as losses.  It doesn’t matter that we are still hugely in profit, all we see is our wealth falling.  Just a year and a half later in early 2009, when we see half the wealth of 25 years of patience wiped out, it is quite likely that we are experiencing something akin to despair.  Loss aversion kicks in and the mere thought of losing any more will weigh heavily on our decision making in the slow climb back to the top.

In the 25 years since inception a lot has happened – perhaps you are getting close to retirement and all of your plans that hinged around your success in Berkshire Hathaway look at risk of coming undone.  Perhaps you had plans to buy a property with the proceeds but suddenly your budget is half of what you expected.  It takes a very special kind of person indeed to hold on tight through all of this.

It’s not just traditional value investing!

Before you think I am having a go at traditional long term buy-and-hold approaches, allow me to criticise factor investing too!  Here is a table from a recent Alpha Architect blog on combining momentum and value strategies (you can find the original blog here):

It shows a couple of variations on value/momentum strategies and their CAGRs and drawdowns etc.  You will see straight away that the drawdowns are just as bad as or worse than those in Berkshire Hathaway!  On occasion these strategies will see you over 20% down in a single month and pure momentum strategies are known for suffering even more severe drawdowns of over 60% or 70%.

It seems that whatever technique we turn to, when we invest in equity we just have to deal with drawdowns.  They are an inevitable consequence of the business cycle and human psychology.  Even if we can’t avoid them though, perhaps we can do something to ease the suffering a little.

Making life easy for yourself…

There is a critical difference between these systematic strategies and the long term buy and hold at Berkshire (or any comparable stock).  That difference is the level of judgement involved in each of the two processes.

Traditional buy and hold investing not only requires a huge amount of accurate judgement and research to accurately identify these companies in the first place, but simply holding on and doing nothing actually requires a lot of work too!  There is no way the precise conditions that lead to an accurate decision in 1980 still hold in 2015 or even in 1990, so to successfully hold a company all the way through you either have to be continually (and accurately) re-analysing the company or be a little lucky…

When it comes to your 50% drawdown (or one of the many 10% or 20% ones), and you are trying to juggle different ideas and analyses to determine if things really are still ok, you are far more likely to fall victim to the above biases and others because you are so much more actively exposed to them.  Now multiply this effort across all the stocks in your portfolio and you have both a full time job and a lot of opportunities to go wrong on your hands…not ideal.

Alternatively, if we take our systematic approach, things start to look a little easier.  While there will still be rough times, the fact that all you have to do is blindly follow a simple system is going to leave you far less prone to errors due to the questions being so much simpler.  The internal dialogue will be more along the lines of ‘does the value premium still exist?’ or ‘does the quality premium still exist?’  If yes, then press on!

Yes, you will still need to be patient.  Yes, you will still need an excellent temperament and no, I’m not saying it will be easy, especially over so long a period as we are discussing.  There is still plenty of opportunity to get nervous, to pull the plug and mess up.  But there are fewer opportunities to do so than with the traditional approach and there is far less subjectivity in the process as a whole.

If we concern ourselves with only answering questions like ‘does the value premium still exist?’, then it is very easy to ascertain this by reading new research as it comes out and looking at the t-statistics and conclusions of the authors.  There is no room for opinion on whether a certain result is statistically significant – it either is or it isn’t and that is a huge advantage…and a big time saver.

In conclusion…

In short, I think that both traditional and systematic methods are very powerful, and they should be because they seek to exploit the same discrepancies in markets.  That said, the skill and effort required to successfully execute the old fashioned way is just so much higher than with a systematic approach.

Being systematic and outsourcing a lot of our decision making process facilitates objectivity, providing that extra little nudge we need to stay on track over our investing careers.  When the inevitable drawdowns come, we will be better positioned to accurately identify whether or not we should continue with the plan.

Ideally, we might take this even further by automating our portfolio to a large degree, removing ourselves even further from the chance to interfere and freeing us up to only focus on keeping track of the few market discrepancies we are trying to take advantage of.  Making it easy for yourself to do the right thing is very likely to have a positive impact on your returns over the long run.

Whatever your approach to equity investing may be, you can be sure you’re in for a rough ride.  Even Buffett can’t avoid this and you should bear that in mind through the twists and turns the market place has in store for us ahead.  In the meantime…why not try to make things a little more comfortable?

Thanks for reading and please do leave comments, questions and criticisms below!