Even the best investors will at times lose their cool and find themselves turning into day traders during periods of extreme market volatility. It’s hard enough losing money when the markets go down, but there is nothing worse than losing money due to your own foolishness.
In this article, we will discuss the importance of maintaining a long-term view on your positions even during periods of market volatility. From our own experience and the experience of peers, we’ve seen that it is natural human tendency to become more and more short-term focused as market volatility picks up. All of a sudden, your amazing one-year stock idea, which just dropped 10%, is no longer amazing. You start nervously shorting high-multiple stocks in order to protect your portfolio. Now, the stock market ticks up momentarily, so you cover your newly shorted stocks and buy back the long you just sold. Now, the market ticks back down. You start shorting the same stocks you just covered.
Even the most talented investors have done this at some point in their career. When it happens, it is a great learning experience in the importance of maintaining a long-term view, but it is often a very expensive learning experience.
Before buying a stock, ask yourself, how will I react if this stock drops 10% tomorrow?
Train yourself to always think about downside and worst-case scenarios. If you are long GOOGL because you think online advertising will grow faster than investor expectations, then, a sudden drop in the overall stock market shouldn’t change your view on future growth rates. Often, a simple correction in the stock market is an opportunity to buy more of your high-quality investment ideas.
Here is a helpful exercise. Look at the size of your overall portfolio, whether it is $50,000 or $500,000. Now, close your eyes and imagine yourself waking up in the morning to find that the stock market has just crashed 10% pre-market. Upon market open, your portfolio will be down at least 10%. Imagine what it will feel like to have just lost $5,000 or $50,000 dollars. You may feel panicked, depressed, angry, sad, or all of the above. You will often hear well-known investors speak of the importance of taking the emotions out of investing, but it takes years of experience and practice to be able to do this.
If you are still learning how to invest, you may not have truly felt what it’s like to lose a lot of money in a single day. Now, go back to our hypothetical scenario. Imagining how you will react in that scenario will help you to prepare for how you will feel when that scenario actually happens. Humans are not robots, so it’s hard to wipe away all emotion.
However, if you understand the emotions you are likely to feel, it will be less of a shock when the real emergency happens. Now that you are prepared emotionally for a drop in your portfolio, it’s time to put your brain in charge and think logically about your action plan.
Action Plan – Formulating your strategy for market downturns
Step 1 – Avoid the use of margin
Many investors (particularly during bull markets) will borrow funds from their broker to buy more stocks than their current equity allows. The use of margin greatly increases the risk of capital loss for investors. For example, let’s imagine an investor has $1,000 in equity, borrows $1,000 on margin from his/her broker, and purchases $2,000 worth of stocks. A 10% decline in the market will result in a $200 loss (at least) for this portfolio, resulting in a 20% loss to the equity.
The use of margin increases the potential upside, but it also magnifies the potential downside. We believe strongly in building a portfolio that can survive any market condition. An investor increases his/her odds of wealth creation by staying in the game long-term and living to fight another day. Margin increases the odds of having to leave the game early.
Step 2 – Stress-test your portfolio
It is important to remember that the individual stocks in your portfolio may decrease more sharply than the overall market during a downturn. The volatility of an individual stock relative to the market is referred to as “beta.” For example, if a company has a beta of 2, this means that investors expect the stock of this company to move 2% if the overall stock market (S&P 500) moves 1%.
For a more detailed discussion on the calculation of beta, refer to Part 2, Lesson 7 in our A to Z Investing Guide.
Using beta, we can calculate the average beta of the portfolio to get a sense for how the portfolio may act during a downturn. Let’s imagine that your portfolio has an average beta of 1.5. If the market drops 10%, we would expect this portfolio to drop at least 15%. However, “downside beta” is often more extreme than “upside beta.” In other words, the 1.5 beta is based on the correlation of stock movements during periods of rising prices and falling prices. In our experience, when prices fall, the stock movements of individual companies relative to the market becomes more extreme.
In other words, the portfolio may exhibit a beta of 2 during periods of high market stress, so this portfolio could potentially drop 20% if the markets dropped 10%. The reason to stress-test your portfolio is to get a better understanding of the magnitude of losses you are likely to encounter during a market downturn, which will help you to prepare when these instances happen.
Remember – investors can survive significant market crashes if they are not investing on margin!
Step 3 – Stress-test the investment thesis of each position
When markets drop suddenly, inexperienced investors often want to cut losses to minimize the near-term pain from the decline. It is important to periodically review the investment thesis for each of the companies in your portfolio and ask yourself if a sudden 10% drop in the stock price of that company will change in your investment thesis in that company.
Assuming your long-term investment thesis of the company is built on sound fundamental research, a short-term drop in the price of that company due to a decline in the overall stock market shouldn’t change your conviction in wanting to own that stock. If it does, then, you probably shouldn’t own the stock in the first place.
Periodically testing your investment thesis in each position will help you to build increased conviction to continue owning these securities even when markets decline.
Step 4 – Leave dry powder
It is often prudent to leave some level of “dry powder” (cash) in your portfolio to buy stocks you like during a downturn. The level of cash you keep your portfolio is based on your personal risk tolerance and investment goals. Our strategy has been to keep more cash when markets are exhibiting very high valuations and to keep less cash when markets are trading at very cheap valuations.
With some cash available to be deployed, we can buy more of the stocks in our portfolio or to establish new positions of companies that we were waiting to buy.
Step 5 – Have your shopping list ready
Remember, when stocks drop, the valuation usually becomes less expensive. If you are looking to purchase a $200,000 house, and then, the price of that house drops to $180,000, would you panic and no longer want that house? If there was something wrong with the house, then, you may not buy it. But if nothing has changed with the house, the lower price should excite you to purchase the house at a cheaper price!
Most experienced investors view market downturns in the same manner. If the financial outlook of a company has not changed, the lower stock price offered during a downturn provides for an excellent buying opportunity. The caveat to this scenario is during periods when a stock market is going down because the overall economy is slowing or entering a recession.
It is often difficult to accurately judge economic conditions in real-time, but consideration should be given to the economic outlook when purchasing stocks during a downturn. If the economy appears to be slowing, the future projections of a company may need to be reset lower. For example, if a company’s earnings estimates need to come down 10% because of a slower economy, then, a 10% reduction in the stock price has not resulted in a cheaper valuation for the company.
Taking into account the fundamental backdrop of the economy and the individual companies in your portfolio, it is time to decide if you’d like to deploy idle cash into purchasing more stock of the companies in your portfolio or establishing new positions.
This is where your shopping list comes into play. During a severe market downturn, you will not have time to figure out which companies you want to buy. You need to think of this ahead of time and have a list ready of which companies you’d like to purchase and at what prices you’re interested in purchasing them.
Step 6 – Avoid excessive trading
During downturns, it is easy to fall into the trap of over-trading the securities in your portfolio. Usually, this occurs with investors who are on margin and are scared of ending up with a margin call due to excessive losses in their portfolio. If you are avoiding the use of margin to begin with, you will be mentally prepared to survive a downturn and more likely to avoid trading too much during periods of high market volatility.
If you know that you can survive the market decline (because you are not using margin) and if you are unsure of buying more stocks, it is better to wait out the downturn than to compound losses with trading mistakes.
Final Thoughts
At some point in your investing career, every investor will experience sharp market volatility that shakes you to your core. As long as you prepare yourself emotionally, build a conservative portfolio, and have a logical action plan, market downturns will become some of your best opportunities to make money.
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
– Warren Buffett, 2008 Shareholder Letter
