Field of play
Wonderful companies at knock down prices
J.P. Morgan is reputed to have said, when asked about the future course of stock market prices: “They will fluctuate.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p23 Simple and obvious as this observation seems, it contains a truth that investors need to reflect on.
In this post I will look at how investors can turn drawdowns from something nasty to something to take advantage of. It will take understanding of what is really going on.
Drawdowns and volatility
Drawdowns are the downswing from a stock market peak to a subsequent trough. Drawdowns go hand in hand with volatility.
Volatility is the up and down swings of the stock market, or of individual stocks, that take place constantly. Volatility can refer to movements over the course of a day or even part of a day. It can also refer to swings that take place over months or years. Many investors have an instinctive dislike for volatility. It is almost like a fear of spiders or other creepy crawlies.
Drawdowns are usually thought of as lasting for a few months and can even extend for a few years. For example, the drawdown from the peak of the Dot Com bubble in 2000 lasted until late 2002. They are bear markets.
What to do
Various questions come up about drawdowns and volatility. Should we ignore them? Can and should we try to avoid them? Or even, can we take advantage of them? The answers to these questions should not depend at all on whether we have a negative visceral reaction to drawdowns and volatility. It should depend on what is best for our investment results over the long term. If an investor really has a bad reaction to them, the answer is not to hide one’s head in the sand. It is better to read about them, learn all you can and gradually desensitize yourself to market swings. Fear of spiders can be conquered by learning how many are poisonous in your geographic region and, of the ones that are poisonous (very few), what is the consequence of being bitten: risk of death or something like a mosquito bite. This might be coupled with purposely touching spider webs and even touching or picking up a spider. This approach is somewhat akin to a course of cognitive behavioral therapy.
Ignoring drawdowns is not a bad course of action. Better though is to take advantage of them. Worst is to seek to avoid or lessen them by focusing on buying particularly low volatility stocks.
Ben Graham and drawdowns
Ben Graham wrote: “In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p101
There are two points here: firstly, whether he wrote that in 1949, at the time of the first edition of The Intelligent Investor, or in 1973 at the time of the fourth edition, it remains true today. Second, all investors should be well aware that a rise of 50% is the same as a drop of 33%. You have $100 dollars in stocks. Prices drop by 33%. Your paper worth is $66.66. It will take a 50% increase in stock prices to get back to $100.
Ben Graham is telling us to expect drawdowns. But, if we were smart enough, could we avoid them?
A portfolio managed by God
Dr. Wesley Gray is the founder and CEO of Alpha Architect, a firm he started in 2008 after earning his Ph.D. and spending several years as a finance professor at Drexel University. In 2016 his firm published a paper he had written titled Even God would get fired as an Active Investor.
The paper was a thought experiment looking at the question of drawdowns in a portfolio constructed with perfect foresight of the best performing top 500 stocks in 5-year periods from 1927 to 2016.
As Gray explains it: “Clearly, these portfolios do not reflect anything even remotely possible in practice. The concept of this research is to capture results associated with a long-term investor (we assume a 5-year holding period) that has incredible stock-picking skill.”
The following chart of portfolio returns is sorted by deciles from the future top 5-year performers down to the future bottom 5-year performers. The so-called ‘God Portfolios’ earned a compound annual growth rate of just under 30% for the 5-year periods. The S&P 500 managed to generate a 10% return.
Now here’s the kicker
However, the ‘God Portfolios’ exhibited very similar volatility and drawdowns to the S&P 500. That is, the drawdowns Ben Graham warns us about were felt by both the S&P 500 and, to a similar extent, by the ‘God Portfolios’. The message is clear and simple. No matter how smart and how successful our investing is, we are bound to experience drawdowns. Look at the following chart from Wes Gray’s paper. I have cut out the oldest data and limited the chart to the modern 50-year period. The five red circles show drawdowns ranging from 20% to 40%.
The largest drawdowns for both the ‘God Portfolios’ and the S&P 500 followed the Dot Com bust in 2000 and the Great Financial Crisis bust of 2008, 35% and 40% respectively. I remember the drawdown in 2008. As I recall, the S&P 500 was down some 38% in calendar 2008. Our family’s portfolio was down more or less the same percent.
These drawdowns are price declines. Investors must keep in mind Warren Buffett’s words in the 2008 Berkshire Hathaway annual report: “Price is what you pay. Value is what you get.”
This insight is at the core of Warren Buffett’s investing success. It is the understanding that prices fluctuate more than values. This means that stock markets are frequently inefficient. In fact they are inefficient enough that investors can take advantage of this.
As I have written before The conventional view of market efficiency is badly mistaken . I’ve written a number of posts about inefficient markets .
What causes inefficiency in the stock market is Mr. Market. Most readers will know about Mr. Market. Let me quote Warren Buffett. It’s always fun to read his colourful vignettes.
Warren Buffett tells us: “Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning, or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”
With some experience in investing, we can internalize the idea that stock markets are frequently inefficient and that prices fluctuate more than values. In volatile markets this presents opportunities.
There’s one other thing. Over the long haul, in spite of all the volatility and drawdowns, the stock market goes up.
Long run returns
Jeremy James Siegel is an American economist who is the Russell E. Palmer Professor Emeritus of Finance at the Wharton School of the University of Pennsylvania. In his book, Stocks for the Long Run (Siegel, 1998), he wrote: “It is clear that the growth of purchasing power in equities not only dominates all other assets but is remarkable for its long-term stability. Despite extraordinary changes in the economic, social, and political environment over the past two centuries, stocks have yielded between 6.6 and 7.2 percent per year after inflation in all major sub periods.” (Siegel, 1998) p.11. In short, he writes, “The superiority of stocks to fixed-income investments over the long run is indisputable.” (Siegel, 1998) p. 22.
We need to put the idea of volatility and long run returns together.
Broad framing and drawdowns
Many investors have trouble Broad Framing an investment as part of a complete portfolio and as part of a long-term investment strategy – that is, they have trouble taking the long view. Many will frame the investment in a stock narrowly and look at the performance of that one stock and the one stock in a short time frame – say in the next days, weeks or few months. A Broad Framing investor like Warren Buffett will look at the performance of the investment as part of the overall portfolio and over the long haul.
A graphic representation of the impact of Broad Framing and long-term thinking is contained in the following chart. It shows the range of likely returns from a portfolio made up of 95% equities and 5% cash over a thirty-year time horizon. The range of outcomes in any one year goes from a plus of over 50% to a negative of over 50%. That is, the one-year bar shows the largest growth (i.e. unrealized or paper gain) or largest paper loss in any one year during the time horizon of 30 years. So, the investor is warned that in year 19, for example, whether or not there has been a previous 50% paper loss, there could be one that year. The graphic talks of ‘potential loss’. Of course, a loss would only happen if one sold at the low point. It can be seen that in a 10-year period the likely range of returns is from an unrealized gain of about 25% per annum compounded to an unrealized loss of about 6 or 7% per annum compounded. In any 10-year period, that is the likely range of unrealized gains or losses. After 28 years, the range runs from about plus 15 to 17% to essentially no expected loss. The average expected return is about 8% per annum gain. This is the Law of Large Numbers in action.
Source: Royal Bank of Canada – RBC Direct Investing Inc.
This chart from RBC is telling us basically the same story as the ‘God Portfolios’: expect drawdowns and volatility but over the long haul, the returns will be just fine.
Taking advantage of drawdowns
The most comprehensive and recent study of drawdowns is a paper from Counterpoint Global Insights titled, Drawdowns and Recoveries Base Rates for Bottoms and Bounces CONSILIENT OBSERVER | May 21, 2025. The authors are Michael J. Mauboussin and Dan Callahan, CFA.
The paper tells a series of stories through the numbers. It is worth reading in full to get a sense of the scale and duration of drawdowns. For example, the authors note: “There is a close relationship between the magnitude of the maximum drawdown and how long it takes a stock price to go from peak to trough. Drawdowns of 95-100 percent take 6.7 years, on average, while those of 0-50 percent take only 1 year. For the stocks that get back to par, the further they fall the longer it takes to get back to the prior peak: 8.0 years, on average, for the 95-100 percent cohort versus just 1.5 years for the 0-50 percent cohort. The data also reveal that the further a stock falls from its peak, the lower its probability of ever again attaining its past apex. Only about one in six stocks that decline 95-100 percent ever get back to their prior peak, while four in five in the 0-50 percent drawdown group do so.”
This suggests to me that there is a difference between the drawdowns following a true stock market bubble, such as bursting of the Dot Com bubble and the drawdowns likely following an ordinary garden variety bull market. Here are my thoughts on bubbles and asset allocation. My thoughts on asset allocation
The Mauboussin/Callahan paper contains a host of quantitative analyses and conclusions. These include, for example: “Academic research shows that stocks that have done poorly in the recent past (losers) produce better returns than the stocks that have fared well (winners). This is explained by the overreaction hypothesis, which suggests that investors push prices beyond their intrinsic value. A closer examination of results for the loser portfolio shows that the median stock does poorly but that the average is pulled up by a handful of outliers.’
These conclusions are based on the analysis of a large number of stocks. It addresses general approaches like Dogs of the Dow, discussed in my last post. It does not speak to a carefully constructed concentrated portfolio.
Another conclusion of the Consilient Observer paper explains: “Researchers studied the behaviors of retail investors regarding stocks they currently own. They found that investors are roughly 50 percent more likely to buy more shares of a stock after it went down versus when it went up. The psychological rationale is that the lower average cost reduces the investor’s reference point, mitigating the likelihood of suffering from loss aversion, the idea that we suffer losses more than we enjoy gains of the same size. This work found that averaging down did not benefit the returns of the investors who did it.” This conclusion addresses the general idea of doubling down a losing stock.
Their general conclusion is that: “Some investors do like to buy more of a stock they own that is down. This lowers their reference point and mitigates the likelihood of suffering from loss aversion. Trying to pick a bottom is a fool’s errand. But we offer some qualitative considerations for whether it makes sense to play a rebound. These include an assessment of whether cyclical or secular factors induced the drawdown, whether the basic unit of analysis is viable, how lumpy investments are, the financial strength and staying power of the company, whether there is access to capital, if need be, and whether management is dealing with the challenges head-on.” This is consistent with the idea of buying superb companies when they can be had a very attractive prices.
Conclusion
Drawdowns are unavoidable. Through stock market inefficiencies, it is possible to buy wonderful companies at knock down prices. With this approach one is not trying to time a rebound in the market. One is simply buying superb businesses when they can be had at very attractive prices. When stocks are on sale, they are less risky than when they sell at premium prices.
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