Imagine the terrifying scene: patrons fleeing in horror, the building blazing, the door hanging by a single hinge, and a trail of abandoned socks littering the parking lot. What is the catalyst of this pandemonium? Socks are on sale. It has always struck me as contradictory that when the price of socks is down significantly, people buy socks, but when the prices of stocks are down, people panic.
While this parable may seem an unfair comparison given the importance of one’s stocks in respect to the importance of one’s socks, there is still wisdom to be gleaned from thinking about the relation of prices to value in the absence of emotion. Warren Buffet told us that “price is what you pay, value is what you get”. When prices of equity securities drop, the future return of those securities is increased based on the income expected to accrue over time. If the underlying earnings power of our securities has not permanently changed, we should be more confident in higher future returns at lower prices.
We still understand that market fluctuations are uncomfortable. In addition, given the need for many of our clients to draw income from portfolios, we do not have the luxury of ignoring fluctuations in the prices of securities. With this in mind, it may be instructive to review a few key components of our investment principles to address how we prepare for market volatility. It is important to note that we are always careful so that we can be prepared to profit from the folly of others instead of participating in calamity.
We demand a “Margin of Safety”, and we never speculate with your money. Our first two investment principles require that all securities we employ to build your investment portfolio, including mutual funds, must adhere to a strict discipline of knowing the value before purchasing securities at any price. In addition, we know what you own. We never purchase securities without a clear plan for how that investment fits into your overall portfolio. When prices drop, we continue to monitor the earnings power of our investments to make sure that the value we received is still significantly more than the going price.
We define risk as permanent loss of capital. Our Third Principle reminds us to not consider fluctuations in prices to be the primary risk that we manage against. We attempt to profit from volatility and we spend our efforts avoiding securities that have a high probability of permanent impairment. This focus on avoiding loss instead of buying hundreds of securities to minimize fluctuations allows us to concentrate our capital in the best ideas of our managers, which studies have suggested increases the likelihood of high long-term returns.
We carefully manage liquidity. Based on our Fourth Principle, your Wealth Advisor works with you to determine your needs for upcoming cash expenditures so that you have the luxury of not selling securities when prices are weak. In addition, keeping a large amount of ready liquidity allows us to “be greedy when others are fearful” by adding to our positions when everyone else is dashing through the parking lot. In most cases we have 2-3 years of required cash on hand so that any short-term fluctuations can be navigated without risk of a liquidity crisis.
We think long-term. Our Fifth Principle dictates that our endeavor is to help you define and reach your lifetime financial goals and to make your money last the rest of your life, and possibly through the lives of your children and grandchildren. This type of long-term horizon requires us to think about your returns over decades, not days; and while we still must pay attention to the risk of drawdowns in your portfolio, we can put into perspective what a small impact short-term volatility has on your long-term success.
We carefully diversify your holdings. Our Sixth Principle reminds us to balance between not taking significant risk of loss in a single security, while at the same time concentrating our capital into our best ideas. We balance between owning exposure to an unwieldy volume of individual securities and spreading our capital sufficiently to cushion against disruptions in a single company, industry or sector.
All of these principles together are the method by which we protect your capital and ensure that your goals are not dependent on short-term market fluctuations. We understand that volatility is emotionally draining and can cause you to lose sleep. Our hope is that our carefully constructed principles help put into perspective the transitory nature of short-term volatility in relation to your long-term success.
As prices drop, we will continue to evaluate our existing holdings and the available securities that have been marked down even more than the securities that we own, so that we can profit from the fear of our fellow investors. We will continue to remain humble in our decision making, we will never take lightly the trust that you give us to make your money last a lifetime and to ensure that your goals are always within reach.
We will continue to keep you updated as the market environment evolves. Please don’t hesitate to reach out to your Wealth Advisor, or to me personally.