The easiest way to answer the question in the headline is to say that it depends on what type of investor you are.
Do you like to take some profit when your stocks are hitting new highs or do you have the stomach to absorb some volatility over the longer-term to wait for bigger, compounded gains down the road?
In effect, do you protect your short-term gains or your long-term gains?
Here’s some thought-provoking context and perspective on that vexing question from Felix Narhi, Chief Investment Officer & Portfolio Manager at PenderFund Capital Management.
by Felix Narhi
“A change in perspective is worth 80 IQ points.”- Alan Kay
Markets are near or at record levels again. Some investors are getting nervous about another possible downturn.
After periods of strong performance recently, and with fresh memories of the crash last spring, we are increasingly asked what we are doing to protect our gains. No one wants to go backwards.
And we know another pullback is inevitable. It’s what markets do. Taking some money off the table after a big run up seems like a sensible thing to do.
But in our view, what you do to protect the gains depends partly on how you think about investing and partly on what types of investments you own.
Inevitable trade-offs – how people think about investing.
“Volatility is the price you pay for performance.” – Bill Miller
The combination of low volatility and high performance seems like investment nirvana. But like unicorn sightings, such occurrences are more common in fairy tales than reality.
Magical thinking can be dangerous. There are always trade-offs in life.
Another related trade-off that investors need to consider is about how value can change over time, which was probably first described thousands of years ago.
“The formula for value investing was handed down from 600 B.C. by a guy named Aesop. A bird in the hand is worth two in the bush. Investing is about laying out a bird now to get two or more out of the bush. The keys are to only look at the bushes you like and identify how long it will take to get them out.”– Warren Buffett
Two Kinds of Investors:
- Volatility focused or “bird in hand” investors – Protect their short-term gains by selling fairly-valued or overvalued holdings quickly.
- Performance focused or “two in the bush” investors – Protect their long-term gains by not selling compounders too soon.
Investors who are focused on low volatility tend to be more worried that a periodic market downturn will rob them of their “bird in the hand” wealth and seek all means available to protect those gains.
Performance-driven investors tend to be more worried that if they react to volatility and sell their holdings too soon, they will lose out on their long-term “two in the bush” returns that come from the potential rise in value in the future.
One is short-term focused. The other is long-term focused. Ironically, sometimes both can be right. But the timing is different.
An investor who sells just before a correction could be right to protect the existing gains, but so could the more patient investor who holds the same stock through the downturn and triples her money over the next five years as it recovers and heads to new highs.
There is no one right answer for all investors all the time. Just trade-offs.
One of the best illustrations of the trade-off made by performance-seeking investors was a tweet by Morgan Housel in May 2017 about the long-term stock performance of the streaming giant Netflix (NASDAQ:NFLX).
At the time of the tweet, the stock was up almost 200x since the end of 2002. Since then, Netflix is up more than three-fold.
A $10,000 investment in Netflix at the end of 2002 has turned into almost $7 million today. The same investment in the S&P500 turned into $58,000.
This massive difference in end wealth is stunning. While the S&P500’s return is certainly decent, a person holding Netflix through all the ups and downs would have been life changing.
Of course, what is missing from this story is the price that had to be paid to achieve it. Gut-wrenching volatility. There were a few periods in that journey when the stock plunged more than 70% from peak to trough.
And many other times when the stock crashed by 30% or more. We doubt anyone held on to their full stake for the entire journey.
Even founder Reed Hastings sold down most of his stock over that time. Since none of us, including Hastings, are investors in Perfect Hindsight Capital, some trimming makes sense.
However, maintaining a stake in a holding that grows at a 43% annualized pace for a long period of time will do wonders to the size of your portfolio.
“Compound annual growth rates (CAGR) always smooth over the volatility and pain to achieve it.” ― Ian Cassel
On a much smaller time scale, we had somewhat similar experiences during the pandemic with several holdings in our mandates.
Like Netflix, we believe they are leaders in their respective industries with long value creation runways ahead.
And just like Netflix, the market drawdowns were just as vicious and undiscriminating.
After reviewing the investment cases for Zillow Group (NASDAQ:ZG) and PAR Technology (NYSE:PAR), we concluded that their prospects had actually improved.
We believed that protecting the potential future gains for clients who understood our strategy (including the capital we ourselves had invested alongside our clients in the Funds) was worth the price of volatility.