Should I Be Bothered by Drops in the Stock Market?

It all depends.  As a long-term investor, which most people are, you shouldn’t necessarily worry about short-term volatility.  The best long-term investments come with the baggage of short-term volatility, that’s just the way it is.  This is where proper diversification and strategies like allocating “buckets” of money for retirement spending come into play so one isn’t forced to make  a selling decision at what is most likely the wrong time to sell.  Maintaining flexibility in your investment plan is being in control, and it’s an extremely empowering feeling.

For example, always being “fully invested” is a very common mistake made by many investors as it’s inflexible and leaves them hoping for the best (i.e. their investments go up).  I’d much rather be in a position where I’m able to benefit from assets rising or falling.

As an investment manager, I certainly do care about short-term volatility, but mostly for mathematical reasons about how to produce the best long-term returns.  If I have a portfolio positioned properly regarding risk tolerance and the ability to fund client goals over the next few years without being forced into a selling decision, then I’m not really bothered by short-term drops.  I can use short-term volatility as an opportunity while maintaining a long-term focus.

Here’s an example to illustrate:

Hypothetically speaking, let’s say you’re looking at a stock trading at $60/share.  You also have a crystal ball and you’re able to see that exactly 3 years from now the stock will be trading at $90/share (a 50% gain, which is pretty darn good for 3 years).  But you don’t know the path that the stock will take to get there, just that it will be at $90 in 3 years.  What would you do?

Obviously there are no crystal balls in investing but you should have conviction in your research so here’s my thought process:  I would want this stock to be a fairly large position in my portfolio.  A 50% gain in 3 years is fantastic and much better than you’ll find in just about all other asset classes at this point based on valuations.

If this stock is going to do so well relative to everything else, and relative to historical average annual returns, should I put all of my money that I don’t need in the next 3 years in it?  While intriguing, I would say no.  It would certainly be easy to invest all of your money in it and forget about it for the next 3 years, but most people can’t do that. What if in year 1 the stock drops to $30 and then rises over the following 2 years to finish at $90?  By buying it all at $60 you would lock in a 50% gain, which is great, but would miss out on the opportunity of making 200% on any shares bought at $30!  If you invest all the money at $60, you’ve lost the flexibility to take what the market throws at you, including the opportunity to buy more at lower prices.  Plus, even if you absolutely knew the stock would be at $90 after 3 years and decided to buy it all at $60, most people would still start to panic after seeing a 50% decline down to $30, start second guessing and probably even sell some “just in case” it goes lower still.

I would approach this investment like so: I would buy a good amount of the stock at $60 but would maintain the ability to add to the position at lower prices.  How much you buy initially vs. holding back as a reserve is dependent upon each investor’s unique circumstances, but I would suggest being able to at least double the size of the position if it drops.  After all, any shares bought at $50 would generate an 80% return moving forward, bought at $45 would generate 100%, bought at $40 would generate 125%, and so on…  All of those returns are larger than 50% so I’d like to make sure I can take advantage of them.

Back to real life.. this theoretical example is based on an actual stock that all of my clients own: CF Industries (CF).  It’s actually the largest “growth” stock that we own.  A couple months ago it was trading in the $60’s and over the last two weeks as the selling pressure spread through various industries, including all commodities and materials, the stock got knocked down to around $45 today…ouch!  Attention clients: if you weren’t happy with your Blueleaf emails lately, this actually accounts for a large portion of the drop in your portfolio value in September.  But is this a bad thing?  Or is this a short-term drop that is creating a great long-term opportunity?  I believe it’s the latter.  I  bought more around $54, $50, $46 and will continue buying as long as it continues to fall.

I cannot find a better growth stock than CF right now, based on valuation, industry (Ags are a very different story than the industrial commodities), company positioning and advantages, capital allocation policies, etc.  It checks all the boxes.

Hopefully this post helps alleviate any short-term concerns by keeping our eye on the (long-term) ball.  With that said, I have been cutting back in other areas/other stocks that I am not as optimistic about and we remain fully hedged against our “growth” allocation.

Thanks for following!

-Nick

CF Industries (CF) – 10 year, monthly chart