Dealing With Volatility: Treat Your Stocks Like You Treat Your Home
Friday, May 13, 2022
Stocks are struggling this year. The major equity benchmarks are down meaningfully, and many individual stocks are down considerably more. Shares of businesses like Zoom, Peloton and Netflix, which did very well in the early stages of the pandemic, have fallen dramatically and are below pre-pandemic levels. More recently, the popular FAANGM group of stocks have come under pressure.
The primary reason for the disappointing stock market performance is inflation. It’s currently high and out of control because central banks made money too cheap and too easy for too long. To correct that mistake, central banks are on a path of raising interest rates aggressively. Equity valuations are under pressure as investors worry this tighter monetary policy will trigger an economic slowdown and possibly a recession. The war in Ukraine, COVID-19 lockdowns in China and ongoing supply shortages and logistical challenges caused by the pandemic are also contributing to investor pessimism regarding the outlook.
While it’s quite possible that equity markets will correct further in the near term, we are increasingly optimistic regarding the medium- and long-term prospects for the stocks we own and recommend.
Central banks are committed to bringing inflation under control. That’s a good thing. Although it will cause some economic pain and contribute to unsettled markets in the near term, it will create a much stronger economic foundation for the future. Overly accommodative monetary policies have fueled inequality and asset bubbles in recent decades, and we believe central banks will learn important lessons from the current battle against inflation. Importantly, we believe central banks will be more disciplined and mindful of inflation risks and other unintended consequences of their easy money policies in the future.
A significant amount of speculative froth has been expunged from the market over the past year, and that has rendered investor sentiment extremely negative. That is positive from a contrarian perspective, as markets are known to climb a proverbial wall of worry. The odds of generating attractive returns over a three- to five-year horizon are always better when sentiment is negative and valuations are depressed, than when investors are optimistic and stock prices are near their highs.
Successful long-term investors understand that enduring periodic episodes of heightened volatility is the price one must pay to achieve the superior longer-term reward that stocks offer. Those who try to time the market invariably do worse than those who don’t. It’s time in the market that counts, not timing the market. For many, their home is their most valuable asset. That’s usually because they live in it and own it for a long period of time. Homeowners don’t typically consider selling and renting when risks of a recession are in the headlines. Portfolios would be better off if people treated their stocks the same way.
As human beings, we are not emotionally wired to do well in assets that can be easily bought and sold. We typically want to buy more shares when the outlook is bright and prices are high. Similarly, we are inclined to sell when the outlook deteriorates and prices fall. Letting those emotions dictate our behaviours is a formula for disappointment over time.
Still, it’s tempting to think one can trade in and out of investments at the highs and lows in anticipation of economic and market cycles. To time the market well, one has to get two things right: when to sell and when to buy back in, and that exercise is fraught with risk. A mistake isn’t just costly at the time that it is made, it compounds over time. For instance, money sitting on the sidelines doesn’t earn interest, dividends and capital gains, each and every year for the rest of your life. Investors sometimes forget that, which is why those who don’t try to time the market tend to do better than those who do.
Another thing that weighs on investors’ emotions during turbulent times are individual stock mistakes, those stocks that get absolutely pummeled. There hasn’t been a period in our history where we haven’t made such mistakes, and this cycle is no different. Mistakes are inevitable, and they are part of the reality of investing in equities. Even the legendary Warren Buffett has a track record of mistakes. One of the keys to being a successful investor is to appreciate that the world doesn’t always unfold as expected. It’s important to move on when an investment thesis is broken and reallocate funds to more promising opportunities. At the end of the day, it’s the batting average that matters. The goal is for the gains on the winners to more than adequately offset losses from the stocks that disappoint. The Odlum Brown Model Portfolio* had its best year ever in 2000 with an annual return of 44%. That same year, nearly a third of our investments lost money. While we always strive for perfection, it’s simply not realistic to participate in the upside stocks offer without being exposed to the downside risks and the occasional mistakes.
We own and recommend a collection of high-quality businesses that are well positioned to survive tougher economic times and thrive in the long term. Valuations have retreated to the point where we believe the odds are excellent that we will achieve favourable returns in both absolute and relative terms over a three- to five-year horizon. Our advice is to sit tight and treat your stocks like you do your home.
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*The Odlum Brown Model Portfolio was established on December 15, 1994 with a hypothetical investment of $250,000. The Model provides a basis with which to measure the quality of our advice. It also facilitates an understanding of how we believe individual security recommendations could be used within the context of a client portfolio. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.
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