Right now, the markets are volatile and that means that even great businesses can get caught in the crosshairs. Why? There are several reasons:
- A huge percentage of the overall market is owned through mutual funds that mimic a major index such as the S&P 500, or are secret “closet indexers,” which means that the fund manager clings to a comparable allocation so as not to deviate too heavily from the bogey. When individual investors panic by selling these funds in their retirement accounts, the professionals are forced to sell shares to meet redemptions, even if they would want to be buying those same stocks hand-over-fist.
- At the end of each quarter and year, some fund managers are thought to engage in what is known on Wall Street as “window dressing”. Imagine a portfolio manager has shares of hard hit companies such as E-Trade, Wells Fargo, or Home Depot in their fund. Even though they might want to buy these stocks in the belief they are huge bargains and will increase exponentially in the next ten years, they don’t want to risk their comfortable, well-paying job complete with paid vacation, health benefits, great suits, and gourmet coffee simply to fight for the business. Thus, they could be prone to dump these shares, hoping to buy them back later during a time period they won’t have to report the position in the letter to shareholders.
- Some hedge funds, realizing these events are at play, could be shorting stocks, driving the prices down even further.
As stock prices fall, more people could panic and this cycle could, in theory, continue or worsen. The good news is that individual investors, private business owners, and those with great reputations such as Warren Buffett at Berkshire Hathaway and Eddie Lampert at ESL Investments can basically tell the market to take a hike, using the cash and assets under their control to pick up positions. If you can stomach paper losses that might run as high as fifty-percent or more, yet you know that the underlying business is fantastic and will prosper over the long run, you have a major competitive advantage.
If you need encouragement, consider that those who dollar cost averaged common stocks during the Great Depression – the worst economic disaster in nearly six hundred years – still compounded their wealth at a good rate and came out much wealthier.
For more information, read Defensive Investing - Building a Portfolio for Volatile Markets