Interestingarticle from Livewire.Something for long-term holders. It suggests that the Drawdowns are part of the wealth compounding process
To reap big rewards in stocks, history shows you must accept thedrawdowns
Investors have beenpromised an elixir of big returns and low volatility. But the truth is that toachieve outstanding long-term returns, investors must be prepared to endurelarge drawdowns along the way – even for the best-performing stocks andportfolios.
While the selloff inglobal equity markets early this year was unpleasant, it was not unusual.Instead of raising alarm, it has been a great reminder that investors need tostay the course with winning businesses – the likes of Apple and Amazon – ifthey want to reap great rewards in the future.
Even the best stockshave big falls
In July 2020, HendrickBessembinder, a finance professor at Arizona State University, published aseries of papers with an important and surprising conclusion: that even thestocks of companies that had created the most wealth for shareholders over adecade experienced deep and protracted share price reversals along the way –often several times.
Bessembinder had becomewell-known after he demonstrated that all the stock market’s value creationover the long run was concentrated in just a few stocks with extremeoutperformance.
His more recent research focusingon the characteristics of those ‘outlier’ stocks, including their interim shareprice movements.
Bessembinder studied thewealth creation of all publicly listed US stocks across each of the sevendecades from 1950 to 2019. He then concentrated on the top 100 performingstocks, measuring their maximum peak-to-trough share price drawdowns.
He found that, on average,the most successful 100 stocks created $US219 billion of wealth over adecade-long horizon. However, shareholders had to endure a maximum drawdown inthe same decade of 33% that lasted for 10 months.
Those shareholders thatinvested earlier in these top stocks, in the decade preceding their decade ofgreatest performance, would have suffered a maximum 52% drawdown lasting 22months, on average, on their way to extreme wealth creation.
Apple and Amazon therule not the exception
Apple and Amazon are twostriking examples of remarkable companies with exceptional long-term stockperformance that have been accompanied by staggering drawdowns.
Apple has created the mostwealth
Applecreated the most wealth in a decade of all the companies in the study, adding$1.5 trillion of shareholder value from 2010 to 2019. But this hasn’t stoppedthe stock from making substantial retracements. For example, in this decadeApple’s share price fell by 40% over 9 months in 2012.
Looking backfurther, shareholders since Apple’s IPO in 1980 have earned a compound annualaverage return of 20% but have experienced drawdowns of more than 70% on threeseparate occasions.
Apple hasdrawn down over 70% three times
Amazon isanother of the most successful investments in history and the fourth-highestperformer in the Bessembinder study, with shareholder wealth growing by morethan $600 billion between 2010 and 2019.
Still,Amazon stock has not been impervious to very large drawdowns. Althoughshareholders from the 1997 IPO have made compound annual average gains of 36%,they also suffered through the dot-com crash of the early 2000s when Amazon’sshare price fell by a gut-wrenching 91%.
Clearly itis impossible to create Gray’s divine portfolio in the real world but that’sthe point. Knowing which stocks to select in a portfolio based on the returnsthey will achieve with certainty would deliver exceptionallong-term gains. But only if investors could stay invested through theshort-term pain.
TheOracle has drawdowns too
Back inreality, Warren Buffett is often seen as the closest to perfection in theinvesting world. The Oracle of Omaha’s performance as the Chairman of BerkshireHathaway has been phenomenal over a long time. Yet Buffet has also been unableto escape grueling drawdowns.
From 1980 to2016 Berkshire’s stock price appreciated at an average annual rate of 20%, faroutpacing the 10% achieved by the S&P500 index. The difference in totalreturn is starker. This means that Buffett presided over a 700-fold increase inshareholder value while the broader index increased 31 times.
Extraordinaryreturns were not, however, associated with restrained drawdowns. Over thecourse of 36 years Berkshire stock pulled back by at least 30% on fouroccasions. Relative to the market these losses were sometimes shocking. Forexample, in the dot-com boom Berkshire fell by 44% at the same time as thestock market advanced by 23%, representing 67% underperformance.
What todo?
So, whenApple, Warren Buffett and God can’t eliminate drawdowns, what are investors todo?
The mostimportant lesson is that investors should identify long-term winning businessesthat are undervalued and own them for the long term too. Staying thecourse has been critical to realizing the powerful compound returns of the bestcompanies even, or especially, as they experience large drawdowns from time totime.
