The timing of the article I wrote and published last week was quite coincidental, considering I wrote the article a few weeks ago and scheduled the article’s publication for last Monday morning.
The title of the article is: Be Greedy When Others Are Fearful. The Merits of Being a Value Investor.
It so happens that the article was published at the beginning of the week of one of the largest one-week market drawdowns, and I happened to start the article with the following sentence:
“I was taking a taxi the other day, and the taxi driver started talking about investing in the markets. He said he was buying the S&P index and hoped it would continue to go up.”
In the article, I drew a parallel between market euphoria, people’s fear of missing out and then jumping on the latest market craze in the hopes of catching the next financial windfall.
The S&P was into that territory at the beginning of last week. Cannabis and bitcoin were there last year.
It’s very difficult to time any market, whether it’s on the way up, or down, and for that reason, I wrote the following:
“As an investor, you need to have an investment thesis and a core belief in what you are investing in. Next, you need a long-term plan. And most of all, you can’t chase the latest and greatest stock or idea of the day.”
My comment about the overheated market isn’t something I wrote about for the first time last week. I’ve been saying the same thing for at least the last year. The stock market is/was overheated. BUT it doesn’t mean you shouldn’t be invested in the markets at all.
What I am saying is that if you’re going to invest into an asset class, whether that’s real estate, stocks, preferred shares, bonds, real assets, distressed debt, private equity, or anything else for that matter, you need to understand the risks associated with the investment, and understand that asset prices go up and down.
If you’re now panic-selling your shares because you can’t stand the large volatility and market drawdowns, then your asset allocation was misallocated, and that’s the reason you need an investment thesis to begin with. You need to ask yourself how much you’re prepared to lose and still be comfortable sleeping at night.
I asked myself that question a number of months ago. I was curious how correlated my portfolio was to the S&P, and so, what I started doing was tracking my daily stock returns with the S&P index so that I could understand how closely my portfolio of bonds and stocks traded to the overall market.
I know, daily tracking isn’t for everyone, but I needed to understand what would happen to my portfolio in the event of a market drawdown. I needed this information so that I could sleep better at night.
My Portfolio Findings
What I’ve done is inputted all of my stocks and bonds into a Google Sheet, and using Google formulas, I can track in real-time how the portfolio is doing. I’ve also broken down these stocks into the various asset classes, so for example, Enbridge, Pembina, Fortis, Hydro One … are classified as Canadian utilities, while Iron Mountain, CoreCivic, Geo Group, Annaly, Welltower … are classified as US REITs. In total, I have 13 asset classes I track.
What I am most curious about is how each asset class does in relation to the others, and how correlated each asset class is to the overall market.
It’s quite possible for the S&P to be up by 50 basis points on a given day, for example, while the US bond ETFs are down, and my Canadian preferred share portfolio is flat.
So every day for the last few months, I’ve tracked the percent change in the S&P and in my portfolio and look at two variables:
- how correlated my overall asset allocation is to the market
- how it trades up or down in relation to the overall market
One day’s worth of data isn’t very telling. One hundred days of up and down data is much more statistically significant.
What the data suggests is that my overall net worth tracks the S&P at an 8.3 to 1 ratio, so if the S&P is up by 83 basis points, my net worth is up by 10 basis points. Similarly, if the market is down by 83 basis points, my wealth is down by 10 basis points. The correlation coefficient is 0.87, indicating a very high relationship on a daily basis between my portfolio and the S&P.
The above doesn’t include all of the interest and dividend income I collect on a monthly basis and doesn’t include the income from my apartment buildings or other sources of cash flow. All it tracks is how my portfolio does as the market goes up and down on a daily basis.
You might wonder why I don’t just buy 15% of my overall wealth in the S&P and save myself the headache of doing all of this work? I’m yielding a 4.1% combined dividend and interest yield on my overall portfolio while the S&P only yields 1.9%, plus, some of my stocks are Canadian and provide me with a better dividend tax credit than the US equivalent.
With the above in mind, I was able to determine how large a loss I would experience if the market were to take a 50% drawdown. I can expect my overall wealth to decline by 6%. (50/8.3). If I add my dividend and interest income, my portfolio will be down only marginally and not anywhere near the 6%.
With this information in hand, I was then able to determine whether my portfolio was properly allocated. I can input a 50% drawdown into the sheet, see the end-result number, and then decide if this is something I can live with or not.
How Accurate Is This Data?
On a day-to-day basis, the ratio varies anywhere from -10 to 100. For example, on February 28th, my ratio was at 2.72, and on February 26th, it was at 112. On that particular day, the S&P was down by 38 basis points, and I only lost a few dollars, so the spread was very large.
In aggregate though, for the five days last week, the ratio was at 8.2. Still not good because my portfolio was down quite significantly, but good because my forecasting methods proved to be a reliable indicator and something I can use to forecast moving forward. What they will help me determine though is how comfortable I am with the ups and downs of my portfolio in relation to the market.
Can I Sleep at Night?
What I’ve determined is that I can take more risk. I only have 17% of my overall wealth in the stock market, and I’ve kept more cash on the side then I otherwise would have so that I can jump in when I’m ready. I also need to keep in mind that I have some of my wealth in other non-market asset classes like apartment buildings, private debt, and private equity which don’t trade in the public markets.
What Will the Coronavirus Do to the Markets?
I should caveat my thoughts by stating that I am providing an economic opinion only, not a medical opinion. My suspicion is the virus will get much worse globally before it gets better, but this will eventually pass, much like every calamity that’s befallen the markets over the last hundreds of years. The economy might stagnate, and we might go into a recession.
And while that’s true, the recession will eventually end, and things will eventually pick up once again.
If you panic-sell your portfolio, when will you feel comfortable getting back in? Hindsight is always 20/20, and unless you have a crystal ball and know exactly when the market has reached a bottom, which you obviously don’t have, your best bet is to understand the level of risk you’re comfortable with. You should make those changes with a clear, level head while the seas are calm. You don’t make those changes when the seas are stormy.
Then, and even more importantly, you should have ready access to some cash in anticipation of what you will do when and if the timing ever does avail itself to your advantage.
Yes, fortune does favor the bold, because it takes a lot of fortitude to jump into an asset when the seas are stormy, but that’s when you’ll achieve the best returns.
The best time to make money in the markets, or in any asset class, is when everyone else is panicking, hence the Warren Buffett saying, “Be fearful when others are greedy, and greedy when others are fearful.”
Is there a competitor who you want to buy?
Perhaps an apartment building you have your eye on?
A stock that’s trading at a crazy low valuation with a low P/E and high dividend?
Maybe buying into a fund that invests in distressed assets, like Apollo, who said the following in this Globe and Mail article: “A downturn would not be a bad thing for Apollo,”
In the above examples, you can mitigate your chances of loss by acquiring an asset at the appropriate time. You don’t buy bitcoin at $20,000 because everyone else is buying. You buy it at $2,000 when everyone else is selling.
Hanging tight and doing nothing is your best chance of success, provided you had sound allocation to begin with. If you found yourself tempted to dump some of your stocks, then it’s likely your portfolio isn’t properly allocated in the first place.
Backtest your portfolio. Figure out what level of risk you’re comfortable with, make sure you have some spare cash on the side. I’ve always recommended a third, as per my bucket strategy, and you can download my book for FREE from here. and most importantly, understand when, where, how, and under what condition you would be prepared to deploy that cash. When your timing happens, pull the trigger.
Remember, fortune favors the bold.
It’s hard to become super wealthy by earning 8% in the stock market. Yes, you can do OK, but real wealth happens when you take the right risks at the right times and swim out to sea while everyone else is swimming to shore.
The wealthy continue to get more wealthy because they can be pragmatic about business decisions. Because they know when and how to take advantage of an opportunity. Because they understand risk and reward and know how to be greedy when others are fearful.
As you can see by the news headlines the last few days, the greater population doesn’t see opportunity. They see fear, and that’s how they operate.