VII #43 — The Most Important Number in Stock Investing

I’ve posted Entry #43 to my weekly Valuation-Informed Indexing column at the Value Walk site It’s called The Most Important Number in Stock Investing.

Juicy Excerpt: Pfau writes: “For every risk measure considered, the market-timing strategies result in less risk and higher risk-adjusted returns than the 100 percent stocks Buy-and-Hold strategy. The highest standard deviation for portfolio returns from market timing is 13.93 percent, compared to 18.02 percent for buy-and-hold. The Sharpe ratios are also larger using two different definitions, showing that market timing provides higher returns on a risk-adjusted basis…. The maximum drawdown, which is the maximum percentage drop in wealth between high points and any subsequent low points in the historical period, is also significantly less for market timing. The maximum drawdown was only 24.16 percent, compared to 60.96 percent for buy-and-hold.”

That maximum drawdown number is now my favorite numerical way of illustrating the secret to successful stock investing. Many experts define risk as volatility. But volatility is often not that big a deal. Moderate volatility, volatility not strong enough to cause you to sell your stocks, will not hurt you in the long run. But volatility that scares you enough to cause you to sell stocks when prices are down can set back your retirement dreams by many years.

So the best way to diminish the risk of stock investing is to invest in such a way that your maximum drawdown number is low. If your worst-case scenario is not that bad, you are never going to feel compelled to sell when prices are low and in the long run you will do fine. Being willing to abandon Buy-and-Hold for Valuation-Informed Indexing in one moment lowers your maximum drawdown from 61 percent to 24 percent. That is no small improvement!