it’s the end of the world as we know it…

Apologies in advance for the bait-and-switch, but this is not an article in which I warn you about imminent financial Armageddon. However, listening to the famous R.E.M. song over the weekend got me thinking –  what if the (financial) world did actually come to an end tomorrow?

 

Broad-based market sell-offs are inevitable and it’s quickly approaching the ten-year anniversary of the last “bear” market… However, in spite of what many pundits may claim, it is impossible to consistently predict when and where the next one will occur. So what are we supposed to do?

 

The short answer is, prepare. When markets go into free-fall everything from the commentary on the evening news to the colour red flashing in your stock terminal have physiological effects that increase short-term focus and sub-optimal decision-making. Therefore, while markets remain buoyant and coolers heads prevail, take the time to make a course of action so that when the “next one” comes, you can slip into a quasi “auto-pilot” and follow a simple checklist, limiting the possibility of making irrational decisions and leading to better long run performance.

 

When I started to give this some thought, I realised that the most important things to remember are:

  1. Keep calm
  2. Go shopping while it’s on sale

 

Keeping calm

Warren Buffett has often describes investing as “simple, but not easy” and the advice to “remain calm” in times of market turmoil is a perfect example of this tenet. Humans are hard-wired to prefer to act with the crowd and find the idea of buying stocks, when many intelligent people are wielding convincing data points that predict the end, almost unthinkable. It’s even been shown that the colour red (typically the default for stocks that have declined in value) can lead to increased stress levels when compared with other possible colours. Get the picture? There’s going to be dozens of psychological red-flags going off in your brain, screaming at you to sell, when you really should be buying.

One of the first ideas I had about how I could increase the chances of remaining calm was to create a list of inspirational quotes, tailored to coach me through a large decline in the stock market. These quotes remind you that this time is not different and can help you keep a clear head. You can access my list here but I suggest you compile your own, given how you react to stressful events is likely to be different and the quotes need to resonate with you.

Another idea I had was to take the S&P 500 total return chart, adjust for a log scale, and stick it on my computer monitor. The rationale here being that, in the short term, market fluctuations will be scary and look severe, but over ones investing lifetime, they diminish into minor speed bumps. Even the greatest stock market crashes of all time, look insignificant when viewed over the long term.

S&P500 log scale

“Be greedy when others are fearful”

– Warren Buffett

 

Go shopping

Once your emotions are in check, the next thing you have to do, to maximize the opportunity a sell-off creates, is to go shopping. I don’t know about you, but when I go to the grocery store, I always take a list of the items I need to buy with me. But, if ever one of my staples is being offered at a particularly discounted price, I’ll buy six months worth! The same philosophy applies for investing. If you wait for a correction before deciding what you would like to own, you waste valuable time and liquidity thinking about what to buy, instead of just buying the “no-brainer” opportunities available. You also run the risk of forgetting about that truly great company you looked at five years ago, passed on because it was trading for an egregious price.

To get around this, I’ve started making a list of desert island stocks. Now most investors keep a watch list of stocks that they have previously researched, to keep track of buying opportunities, but this list is reserved for the truly wonderful businesses that you only come across rarely. These are the types of businesses that have an extremely high likelihood of still being around in 10+ years and generating higher levels of profits than they currently do.

There’s two important points that you must follow when compiling your own list. Firstly, you must prepare the list before a significant market decline. This will allow your frontal cortex to dominate the thought process and not become clouded by the fear generated in a market decline. Secondly, I think it’s vitally important that you determine a price at which the stock becomes a no-brainer. Again, you need to do this before the stock begins declining to prevent anchoring and other behavioral biases creeping in and affecting your judgement. This has the added positive of allowing you to essentially turn on cruise-control when markets begin to decline – you’ve already done the hard yards researching a company and determining a price at which the stock is extremely unlikely to generate a poor return over the long run – now all you have to do is follow your instructions.

 

The final point to discuss is that in order to take advantage of negative market events, you need to have cash available. Again, this is much easier said than done. However, there are a few tips that I use to ensure I’m always prepared to take advantage of these opportunities.

For starters, it’s very rare that my portfolio is 100% invested. There’s a quote by Munger that goes something like it’s always worth having a spare $10m in the bank, and while I’m not fortunate enough to have that sum lying around, I think the concept applies to everyone. Nobody knows when markets are going to violently turn down, but it does tend to do so quite frequently, therefore, having some spare cash around to plug in at points of extreme pessimism seems logical to me. On average, I tend to keep 5-10% of my net worth in liquid bank deposits for these situations.

The other point is around structuring your portfolio in an anti-cyclical manner. What I mean by this is that as the market moves higher, value investors will typically increase their exposure to cash as investment opportunities become scarce. Mohnish Pabrai often discusses his portfolio management approach and it’s something I’ve adopted too:

  • He is willing to be 75% invested in ideas that have a 2-3 year expected return of 2X
  • If he can find ideas that have a 3X expected return he will add them in and increase the equity exposure to 85%
  • If he is able to find 4-5X opportunities he will go to 95%
  • And if there are opportunities with expected returns in excess of 5X he goes all in

I think this is a logical framework to use:

  • 75% invested most of the time
  • 85% invested when there’s lots of opportunities around
  • 85%+ when there are abundant no-brainers

 

And finally, cash has the added benefit of becoming a larger percentage of your overall portfolio as markets decline. For example:

  • Imagine you have a $1,000 investment portfolio with $750 in equities and the rest in cash ($250)
    • Your cash weighting is 25%
  • Now assume equity markets fall by 50%
    • Your equity holdings are now worth $375 but your cash has remained at $250
    • Therefore, the cash weighting of your portfolio has increase to 40%

 

While we can’t predict when markets will experience a sharp fall, we can prepare. As Michael Stipe said,

“it’s the end of the world as we know it… and I feel fine”

 

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