Can You Cope with Declines of 50% or More?
“If You Can’t Stomach 50% Declines in Your Investment You Will Get the Mediocre Returns You Deserve”
The world breaks about once every decade - history rhymes, as they say, and you have to be prepared for that. This is the unvarnished truth about investing, and I’m going to explain it directly, because I really want you to understand it.
Ulysses Investment Pact
To help you, I’m going to explain the Ulysses Pact, which I’m considering bringing into my business from an investing point of view. A ‘Ulysses pact’ refers to the pact that Ulysses (the legendary Greek King of Ithaca) made with his men as they approached the Sirens (dangerous creatures, who lured nearby sailors with their enchanting music and singing voices).
Ulysses wanted to hear the Sirens' song, although he knew that doing so would render him incapable of rational thought. He put wax in his men's ears so that they wouldn’t hear the song, and had them tie him to the mast so that he couldn’t jump into the sea even when he felt tempted to go to the Sirens.
He ordered them not to change course under any circumstances, and to keep their swords upon him and to attack him if he should break free of his bonds.
Upon hearing the Sirens' song, Ulysses was driven temporarily insane and struggled with all of his might to break free so that he could join the Sirens, which would have meant his death.
So, how can we apply this in an investment setting? Well, it would be a pact you enter into prior to an event, especially if you know you’ll react irrationally given a particular set of circumstances.
Successful investors create a Ulysses pact with themselves. In essence the pact would say:
“I will never sell my investment portfolio as a result of market or economic conditions; I will only ever sell an investment portfolio if my financial plan dictates it and I require the cash to support my lifestyle.”
The most important question you need to ask yourself, if you’re going to be a successful multi-decade global equity investor - and you have to think in multi-decades when it comes to investing, because investing doesn’t have an end point – is:
“When the next deep, scary, temporary, stock market decline of -50% or more comes will I take absolutely no action as a result of this market movement?”
Remember that all of your capital you’re investing now for your family will be for future generations. You might dip into it to support your lifestyle, but you’ll be able to pass it on, and you’ll have taught those who come next how to be wise with their money.
Or, look at it this way: “When the next deep/scary temporary stock market decline of -50% or more comes I will act with equanimity (mental calmness & composure through a difficult situation) and sloth (be lazy) and not react to the crisis of the day and try to time markets.”
I’m seeing more and more end clients starting to want to time the markets again. They see the outlook as negative, and want to act, because human nature is a failed investor.
Humans, stop trying to time the freaking stock markets! You won’t out-think them, because short to medium term they are unknowable. All declines in global equities have been temporary, albeit painful to the investing illiterate.
The declines are the admission price to long term wealth, in order to benefit from the advance, you have to be willing to ride the declines. The financial robot - the ‘econ’ devoid of any emotions - does absolutely nothing through these declines.
At the time of writing this, the world has just lived through a very scary period, and I think it’s important to talk about this, to take stock and look at how we’ve responded to the events. Lessons can be learned.
I’ve now lived through and invested through two such declines, in 2008 and 2020. 2008, from the high point to the lowest, dropped -58%. You’d have been very unlucky to have invested 100% of your capital at the high point, just before the market declined. Most people didn’t suffer that decline.
The -58% decline quickly bounced back, but that is a deep, deep decline that financial literates lived through. Remember, all these declines are gifts for the monthly investor, and the value is off the charts, because a declining market is a rising in value market.
In 2020, we’ve had a deep decline, and it bottomed out in the middle of March at around -35%. We expected that the markets would continue to go down, and lots
of financial illiterates were caught off guard by it. because they don’t know what they’re doing.
My personal portfolio went down by more than that, as I have more exposure to emerging markets, small and value companies, but I know where the returns come from and I’m fine dealing with the extreme volatility of temporary declines.
Warren Buffet’s definition of risk is: “Risk is not knowing what you’re doing.”
Investing in the stock market is not ‘risky’ for me, because I know what I’m doing, but it is tricky for people who don’t know what they’re doing. The stock market is magic if you let it do its thing, which is create serious wealth.
It’s a wealth accretion machine, and long-term you can expect roughly 10% compounded returns over multi-decades, IF leave it along to work its magic, so get out of your own way, people!
Of course, if you have decided to respond with equanimity during the next decline, then you can continue to invest in the global markets. Charlie Munger is 96 years old and has lived through three extreme recessions, and he says they don’t worry him at all.
Three Ways to Soften the Blow When the Next -50% Comes
1. Don’t invest, leave it in cash; get hammered by inflation and remember that the media are hell-bent on derailing the financial illiterate.
2. Add an emotional asset class into your portfolio; the intellectual financial asset class is global equities, because it’s out-performed everything else over multi-decades. That’s where I put my money, and all financial literates put their money.
If you can’t deal when the next -50% comes, you need to soften the blow by sprinkling in an emotional asset class. This is known as fixed income, government bonds or corporate bonds.
I’ve invested 100% of my families’ capital in 100% global equities, I can ride out the storms and act with equanimity. If you don’t quite know what you’re doing, you could invest in the 50/50 portfolio: 50% equities and 50% fixed income. The fixed income market is slightly bigger than the global equities market at the moment.
During the recent great sale, instead of -30%, a 50/50 portfolio would have been nearer to -15-20%, or about half of what others experienced. Remember that the market advances about 75% of the time and declines about -25% of the time.
These are great odds, but just bear in mind that fixed income is not a financial or intellectual asset class, because it will underperform compared to equities, but it will stay ahead of inflation.
When the markets are flying and you’re in a 50/50 portfolio, you will not get the return of the market. However, badly-behaved clients, who have a mental blind spot in the bad times, will say, “Oh, but my portfolio hasn’t done as well as the market”.
You have to pander and build these portfolios because people can’t deal with the decline. The best portfolio is the one you stick to. There is no point setting up something you’re not going to stick with through all market cycles.
3. Have a comfortable cash pile, because then you can then pay less attention to the declines in your investment portfolio. You should also have an emergency fund, and may have some cash in fixed income assets rather than all of it in global equities. During a decline you don’t have to touch your equities.
Most can’t smile at the -50% decline, so they have to add fixed income to soften the blow during deep panics. You can join me, Charlie Munger and many others who can, but remember that Charlie says: “Becoming rich and wealthy isn’t easy; why should it be? You have to ask yourself and contend with tough questions.”
Don’t forget, the next decline is WHEN, not IF, so ask yourself: “When the next deep, scary, temporary stock market decline of -50% or more comes will I take absolutely no action as a result of this market movement?”