Why doing nothing is not a strategy
During this ongoing market volatility we’ve heard from a number of sources, including famous billionaires (like Mark Cuban), that if you don’t know what to do in the ongoing environment – do nothing. While on the surface, this advice seems sound, and what you certainly don’t want to be doing is panicked selling, we do feel that if you dig into what this advice means it doesn’t quite hold water. Now this applies a little less for passive investors, but in our experience, very few investors are truly passive.
So dear reader, if even part of your portfolio is non-passive we believe that ‘doing’ nothing can be an incorrect strategy, which we will discuss further in Part I below. In Part II, we discuss what makes following the framework of ‘doing something’ difficult (and how to overcome those difficulties). Do note that Part I isn’t based on our original thinking (we’re not that smart), but based on Lee Freeman-Shor’s book “The Art of Execution” (which we highly recommend you read). Part II however is based on our experience implementing this framework with our clients, and the difficulties we’ve come across.
Part I: Why you shouldn’t do nothing
Once you own an asset (any asset) and the asset has an extreme drop in price (which most assets have seen during the last month and a half) you really only have three choices. 1) Buy more 2) Hold or 3) Sell. Now it’s incredibly hard to tell what the right strategy is but what we can do is simulate if a decision will be correct based on what we think might happen. So we will try to do that below, by filling out the table that follows.
Now, let’s explore each action and see if that decision was correct based on what happens to the asset price.
Possible Action 1) You buy more of the asset
Asset price falls further: Buying was the incorrect decision
Asset price stays the same: Due to the time value of money, buying may be an incorrect decision.
Asset price rises: Buying was the correct decision
Possible Action 2) You sell the asset
Asset price falls further: Selling was the correct decision
Asset price stays the same: Assuming you sold the asset and reallocated to a stronger asset this might have been a correct decision
Asset price rises: Selling was the incorrect decision
Possible Action 3) You hold the asset
Asset price falls further: Holding was an incorrect decision
Asset price stays the same: Holding was incorrect decision as time value of money erodes the value of your asset
Asset price rises: Holding was an incorrect decision (you should have bought more)
Now if, based on the above analysis, we fill in the chart, a picture starts to form.
Now it’s clear from the table above that there are situations when buying is the correct choice and others where selling is the correct choice. Deciding between these two is a matter of odds, the calculation of which is complex and beyond the scope of this blog post. But what the clear takeaway is that no matter what the correct choice (buying or selling), simply holding is the wrong choice. Again, the goal of this framework is to not tell you what the correct choice is, but to point out what the wrong choice is.
Part II: The limitations/difficulties of applying this framework
While theoretically the above framework makes sense to us, we realize we invest in the real world and that leads to some difficulties. So below we discuss the limitations of this framework and possibly, how to get around those.
1) Magnitude of the fall – the above framework really only applies when you have large movements down (20-25%+), small movements of 5-10% don’t really apply. The reason is that it is not too hard to recover from a 5-10% down movement, but as assets fall further the harder it is to recover. To take an extreme example, if an asset falls 90%, you would need the asset to grow 1000% to recover your original capital.
2) Too many assets – this framework is very difficult to implement when you have dozens upon dozens of assets. Diversification has its benefits, but over-diversification has significant drawbacks[1]. We’ve seen this happen with our clients, when their entire portfolio is down 20-30% no matter how much capital they have they have, its hard to spread it around adequately. In this situation you either need to consolidate asset or put more capital behind only your best ideas.
3) Too little money – This is very common as investors tend to ‘over-invest’ by either being leveraged or having a close to zero cash balance. In this case you may have to make tough choices between your assets and sell the ones you are less bullish on and add to the ones you feel have much better future prospects.
4) Time frame – Sometimes clients ask what time frame they should use when determining if buying or selling was the right decision. We find this is not the important question. The more important takeaway is that no matter what the time frame, just holding is not the optimal decision.
5) Over-allocation of initial capital: Say you decide that an asset is being unfairly punished by the market and you keep buying as the asset falls. It could mean that you end up committing an inordinate amount of your capital to the single position, which can be risky if you’re wrong. Thus, unless your certainty is very high it may make sense to sell the position (or some of it), no matter how hard this is to do mentally when you’ve committed so much. But again, even in this case “holding” isn’t the rational choice (but sometimes the easier choice!)
6) Passive/Long-term Investing – we typically see that when our customers have an asset that’s fallen 30-40%, it quickly goes into their “long-term” holdings bucket. While we agree you should invest for the long-term, we hope the above shows why just holding isn’t a good strategy. Even if you’re just buying broad index ETFs and don’t need the cash for 10-20 years, it would be a bit silly not to buy more after a large market-selloff , especially if you have spare capital.
7) Magnitude and Amount: Say you really like the asset you hold an want to buy more on declines. But the question becomes how much to buy and at what levels? This is more of an art than a science, but we’ve observed sharp investors buying little bits on each 20%-25% decline or seen them wait and buy a whole lot on 50-60% declines. Typically we recommend the former rather than the latter.
In Conclusion:
We realize that the framework we’ve presented is simple to understand but can be difficult to implement both on an operational and emotional level. Remember investing is not complicated, but that doesn’t mean it’s easy! We also know that each portfolio has its nuances and each situation is different. But do note, when asset prices are falling, just ‘holding’ is rarely a rational decision, so while you may not always follow this framework, do bear it in mind when you’re making choices about your portfolio. We wish you all the best.
Happy investing and as usual during this period, stay healthy!
[1] Unless you’re applying some sort of quantitative strategy.