Published May 19, 2017
When we talk about risk we usually think about our potential for losing money. But there is obviously a very big difference between losing 1% of our portfolio and losing 10% of it. We can use the size of the investment to manage our risk. To do this, we determine how much money we are willing to “lose”. For many investors, “losing money” is code for how much we are willing to see our account value decline before we feel compelled to take some action – e.g. our tolerance for “pain” in the investment. We can use this pain threshold or risk tolerance to decide how much money to invest. For example, the stock market can easily drop -5% over a few days, as we’ve had a glimpse of this week. If we can only handle a $5k decline in our account before feeling compelled to take action, we would want our investment to be not more than $100k. A greater amount opens us up to larger $ losses.
The formula for arriving at the investment amount would be:
$ decline allowed / max expected % decline in security = maximum amount of investment
Putting the numbers above into the formula we would have:
$5000/5% = $100,000 maximum investment
If you invested $50,000 then you could withstand a 10% decline in the market before your pain threshold of $5000 is hit. If you invested $200,000 then you would hit your pain threshold after only a -2.5% drop – which could be a one-day move in the market.
For the above approach to work, we need to know what the typical “range of motion” or volatility of the investment vehicle can be. While the stock market overall might see a +/-5% move as somewhat significant, an individual stock can easily move 3-4 times that much, e.g. 15-20%. The wider the range of motion (volatility/standard deviation), the smaller the investment. And, the narrower the range of motion the larger the investment can be. Chart 1 below shows the intra-year declines the stock market encounters. The red dots below the bars display the maximum drawdown or decline for the market in that year. You can see that it’s typical for the market to suffer a near-10% decline during the course of a year. As an investor in the stock market, we should expect such a move and adjust our investment approach to be comfortable with that. Here at TimingCube, we find that comfort in the sensitivity of our models to make the adjustment when the market has decidedly changed direction.
Chart 1: Stock market returns and intra-year declines
An additional consideration can be the timeframe of the investment. Over a 10-year period, the stock market does not lose money – it almost never has (and even when it did the losses were minimal). The longer your investment time horizon, the less you need to worry about the short-term declines of the market. So, if you’re investment horizon is very long, then buying and holding stocks becomes a question, not of how much I might lose, but rather how I can maximize my gain. However, if you are retired and you might need a chunk of your portfolio within 3-5 years, you absolutely must focus on the risk because the declines in the market might come at the worst possible time for you. Investors who built up their retirement in the 1990s were feeling very good until the early 2000s came along and severely damaged their nest egg.
Chart 2: Rolling 10-year returns for stocks
How much risk we can handle is a very personal aspect of investing. It’s different for everyone. Our experience is that most people can handle a decline of around -8% before becoming significantly concerned. Interestingly, that turns out to be about the typical stock market decline in a given year.
Our approach is to maximize our gain AND minimize our risk by avoiding the downturns. If we don’t expose our money to the terribly bad years that the market can encounter, we substantially increase our returns. To our way of thinking, that is a much better way to invest, regardless of your timeframe.
Stocks faced their biggest test in months this week as concerns rose that President Trump’s tax reform agenda would be derailed. It is this tax reform expectation that has helped push stock indexes to new highs recently (along with a sharp recovery in corporate earnings). Monday’s trading session kicked the week off in positive fashion with oil prices recovering and investors ignoring a widespread computer hacking attack. The +0.5% gain was added to only in the tech sector (+0.3%) Tuesday with large-cap tech stocks and semiconductors having another strong day. Brick-and-mortar retailers continued to struggle with the exception of Home Depot (HD) whose stock marches ever-upward on nonstop sales and earnings growth. Stocks hit the wall hard Wednesday after a New York Times article suggested that President Trump might have meddled in an FBI investigation. As issues surrounding the Trump presidency escalate, investors fear his pro-business agenda and tax reform might fall further away from becoming reality. With stock valuations stretched on optimism over those possible policy changes, investors were quick to exit stocks on the negative news for the Trump Administration. The leading Nasdaq index slid -2.6% in its worst loss in many months. Cash flowed into safe haven assets such as U.S. Treasury bonds knocking interest rates down notably. But the selling proved to be a one-day wonder with buyers reversing a negative open on Wall Street to send stocks higher by +0.4% Thursday. Brazilian stocks plunged over -15% on news of a possible bribery scandal involving their president. But there was no effect on U.S. stocks. Friday’s effort saw another recovery move with stocks adding +0.7% on upbeat earnings from equipment maker John Deere (DE). Of note, interest rates did not budge Thursday and Friday, holding Wednesday’s gap lower. Thus, the cash that headed to the bond market for safety during Wednesday’s stock market plunge stayed there, perhaps wary of the stock market’s rebound.
For the week stocks as read by the S&P 500 (SPY) gave up a surprisingly slight -0.28%. The Nasdaq 100 (QQQ) dropped -0.55%. Small-cap stocks fell back into their months-long range losing -1.08% on the week.
Warm wishes and until next week.