Thursday, March 16, 2017

Investor secret No 1: How to deal with the next bear market! And Wall Street hates it!

Do you think you can play guitar and sing as well as Paul McCartney? Malcom Gladwell thinks it takes a bit of talent and at least 10,000 hours of jamming. So 7 hours a day and 220 working days per year that means 6.5 years of hard work. Well there are lots of financial experts who must have done that but who has out outperformed Warren Buffett? Are you goanna do that to achieve a blissful retirement?

You know how many have tried to figure out which company is the next Microsoft or Apple or…?   The beauty is that you really don’t have to be a stock market addict to achieve your financial goals and probably you can do it with plenty to spare. You don’t even need a lot of financial advice. What you do need is time, living below your means and… being stubborn like a Dutchman. Yeah, I know… If you aren’t Dutch, you aren’t much! Bad luck. Just like Warren said, his birth in North America was a lottery ticket win. So, if you are not Dutch like me, well… it was nice knowing you. 
Just Kidding. But a bit of strong headedness (is that English?) doesn’t hurt and I will show you why. Maybe that motivates you to build a bit of Canadian backbone. Oooh, eh was that not entirely political correct? Anyway, back to serious money matters.
So, I made this spreadsheet. Regular victims of this blog may be aware that I recommend to take profits and build cash now that the bull market is so advanced. But is that really the crux of making big money? Typically, I do have cash when approaching the peak of obvious screaming market tops such as during the high-tech bubble. But other crashes came out of nowhere. As so many tell us, market timing is impossible. My spreadsheet starts in 2016 during which we in Canada had an excellent stock market (close to 24% return or so). Then, I let the nightmare begin with a 30% crash in the first 6 month of 2017. So, after such a fall stocks are on sale and the scenario switches to buying stocks with a vengeance. But, gosh, the timing was off and in the 2nd half of 2017 the market loses another 5%. Thankfully this is not a very long bear market. By June 2018 the market has regained its 2016 highs. So it lost 35% and had, to get back to the same level, i.e. make on the remaining money a 53% return. The last half of 2018 is flat. The market returns 0. What is the result in January 2019?
Fig 1. Portion of spreadsheet showing calculations for 2016 to determine results of investment strategy Case I on net worth.

Well, I have 4 cases that run through this market scenario. All start with a $200,000 portfolio.  Case I with little cash (95,000 in the stock market, 100,000 in real estate and 5% in cash). Case 2 is the ‘high cash’ scenario. $65,000 in stocks, $100,000 in real estate and $35,000 in cash. Who will win by January 2019?  Case 3, is the Panic scenario. We starting out with the Case 1 but after the market crashes 30%, the investor sells all his stocks in a panic and stays out of it until January 2019; well after the market has recovered. LOOSER!  The last is Case 4 – PERFECTION. Just like Case 1 this investor stays low in cash but just before the 30% crash he sells all his stocks. Then he starts buying in January 2018 just when the market takes off. Nobody, except liars, do this consistently. But heck, who wants reality?
So stock investments earn an average 2.5% dividend and the real estate appreciates steadily at 3% per year and cashflows 3% of asset value in net rent. Not entirely realistic but close enough.  Oh, see those guys in Vancouver and Toronto laughing?  (Not for long I think). The spreadsheet with Case 1 is shown in figure 1 (sorry it’s a bit long and had to be chopped).  Anyway, who is looking at it closely anyway. The results are graphically displayed in figure 2 (including calculation errors, although I did my best to not make them).
This was a bit of a shocker for me. I thought being well positioned in cash would make me oodles of money. You can see on the graph what really happened.
Figure 2. Results of various strategies during the fictional bear market of 2017.

Case 1 – Low cash did do OK.  Net worth in January 2019: $264,965
Case 2 – High cash did better. Net worth in January 2019: $267,806 – Better but not a lot.
Case 3 – Panic. Oops   Net worth in January 2019: $214,826. Thanks a lot for real estate. Otherwise he would have lost close to 10% of his net worth. Now he is a bit head.
Case 3 – Unreal Perfection. Net worth in January 2019: 324,058.  Wow. But then nobody is perfect. So, if something is too good to be true, then…

The real lesson is: Never sell in a panic! Have always enough cash to live from and wait out the bad times. Other than perfection, a diversified portfolio will get you through. Even if you did not have the real estate.  Without the real estate you would have accumulated less cash during the downturn for reinvestment in stocks. Also, your net worth would have shown much larger ups and downs which is not good for your stomach and your imitation Dutch strong headedness. A less volatile net worth helps you to not sell in a panic.   Real estate and stocks are not well correlated. Although in 2008 both crashed simultaneously. The only thing that held up well and peaked in 2011 was gold. So, being diversified in asset classes such as stocks, real estate, precious metals and cash helps you combat panic attacks because it reduces volatility.
The real world is filled with numerous scenarios and cases. The investment game is different every day but some basic investment truths, not always in favor of Wall street or your broker, remain. Don’t panic and diversify. The rest is window dressing. I am becoming more and more a fan of Market Index ETFs. Maybe a topic for another post.

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