How to approach volatile assets and potentially build more wealth in 2018
Prospect theory states that investors are more likely to make decisions based on potential gains or losses rather than the final outcome. We also know that the most emotionally painful part of any investment is when it begins to lose its value. That decline in value, measured from peak to trough, is called a ‘drawdown.’
The enemy of wealth building
Drawdowns are the enemy of wealth-building. If an investment suffers a 50% decline, then we need to earn 100% to get back to even and resume compounding wealth. Stocks have lost 50% and never gained more than 34% in any one year since 1980.
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While small drawdowns are acceptable and inevitable, large drawdowns (-15% or more) are like pushing the pause button on wealth building.
Source: Bloomberg, JPMorgan Guide to the Markets, Fourth Quarter 2017
Volatile assets will suffer drawdowns more frequently. Standard deviation is the most common measure of volatility, but standard deviation reduces the investment down to a single number, which can be difficult to conceptualize.
Another way to compare an investment’s volatility is to look at the number of daily 3% moves – that is, did the price appreciate or depreciate by 3% or more in a single day.
Since January 1950, S&P 500 investors have seen 204 such daily moves. Bitcoin investors saw 160 in 2017 alone (as of December 28, 2017).
For Bitcoin, these moves have been primarily in a positive direction, much to the delight of investors and the financial media. The price of Bitcoin appreciated approximately 1,500% in 2017; $10,000 invested in December 2016 would be worth over $147,000 (as of December 28, 2017).
But at what cost?
We know from prospect theory that investors crave safety when the pain of loss grows too great. Oftentimes, they will sell their investment to cash or move to a less volatile asset. Experiencing frequent drawdowns of -15% or more can tempt investors to seek this kind of pain relief.
Bitcoin investors witnessed 84 such opportunities to ‘cry uncle’ and sell in 2017.
This is the double-edged sword of investing in volatile assets: they can produce above-average returns, but often expose the investor to deep and sometimes frequent drawdowns. That creates more opportunities to sell the investment and miss out on the gains.
Risk management approaches
Fortunately, investors who seek the returns that volatile investments can produce, but wish to limit exposure to drawdowns, have options beyond simply riding it out.
Hands-on investors may enjoy reading Meb Faber’s white paper titled ‘A Quantitative Approach to Tactical Asset Allocation.’ For those who prefer to outsource this part of their portfolio, consider adding a manager with a disciplined, systematic approach.
Either way, options exist beyond a simple buy-and-hold approach. This year, resolve to spend less time in pain and more time compounding your wealth.
 Technically speaking, an investment is in a drawdown anytime the price is not hitting all-time highs
Article by Longboard Funds