The Only Two States of Your Portfolio: Happy All-Time High or Sad Drawdown

emoinvestQuick question – What was the highest value ever for your investment portfolio? Now, what was the value exactly a year before that? You probably know the answer to the first question, but not the second, even though both have little to do with your final portfolio value.

I am currently reading the e-book Global Asset Allocation by Meb Faber and he had a good observation that I don’t recall ever expressed in this specific manner (emphasis mine):

It is a sad fact that as an investor, you are either at an all-time high with your portfolio or in a drawdown – there is no middle ground – and the largest absolute drawdown will always be in your future as the number can only grow larger.

We tend to carry the highest value of our portfolio around in our heads because of the powerful cognitive bias of anchoring. Let’s say that 10 years ago you started with $20,000 and today with your contributions and investment growth your total is $100,000. If next year your portfolio experiences a drawdown to $80,000, you’ll probably identify your portfolio as being 20% down from $100,000, as opposed to a 400% increase from $20,000. $100,000 is “what you had” and you will forever be anchored to that number, even if for it only lasted just for a day.

That is, until you reach another all-time high (yes! $105,000) and that will be your new anchor. (This applies to individual holdings as well – I’ve found this especially pervasive when using brokerage smartphone apps that allow me to frequently check in with just a tap.)

If your portfolio is anything like mine, it has been repeatedly been hitting all-time highs for a year or two. The problem is, sooner or later, there is a 100% chance I’ll be stuck in a prolonged drawdown phase. I will think about my high-water value every time I check my statements (which is why perhaps it is better not to check your investment value much more than once a year). I will question my existing asset allocation and how to invest my new money.

Now add in loss aversion – the other finding from behavioral economics that people feel the pain of losses much more severely than the pleasure of gains (studies suggest we hate losses roughly twice as much as gains).

That means drawdowns are always lurking around the corner, and we hate them twice as much as any investment gain. It’s no wonder that investors are often their own worst enemies by not sticking to their investment plans.

Comments

  1. Interesting article. I never thought about anchoring before, but it seems true for me. The loss aversion thing is real too. However, as an active investor, and one who likes to learn, I’d rather try to master my emotions than stick my head in the sand and not look at how my investments are doing.

  2. Yep… AAPL hit $133 on Feb 23, and is currently at $125. It’s still up 60% compared to a year ago, but until it hits $133 again, I just see it almost as a negative number.

  3. Well, this is not necessarily true if you are young and have a long term horizon. Since investing for retirement is all about dollar cost averaging over a long period of time (several decades), if you are in your 30s, then you are actually happy when the market goes down, so that you can buy more at lower prices. Of course, if you are an active trader and are trying to make money now, then this article is certainly true. I have done active trading for way too long and now realizing that passive long term investing is the best way to prosperity.

  4. I’m curious about Faber’s Cambria Global Asset Allocation ETF. It’s basically a “free” asset allocation ETF with underlying fund expenses of 0.29%. That’s pretty cheap if you agree with the allocation.

    It’s kind of like a one off version of Schwab’s Intelligent Portfolios. (Without the large cash allocation…)

    Symbol is ARCA… Interesting approach.

  5. Well, this is one of the reasons I’m attracted to dividend growth investing. I look at my stocks as long-term business partners. I understand the price of the stock will wiggle irrationally high or low day to day or quarter to quarter, but my focus is on seeing a rising portfolio dividend payout year after year.

    Stay well diversified, don’t chase yield, use a little common sense, monitor, occasionally rebalance, hit consistently for singles instead of swinging for the fences… and you can see new income highs year after year after year.

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