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Return Expectations & Drawdowns

Say you invest $100 at x date. What are the chances your market value will be higher or lower than $100 at x + n(months)? The answer may surprise you.


This concept was presented at the Real World Risk Institute in February by Dr. Robert J. Frey. Dr. Frey is a brilliant investor; he was a partner at Renaissance Technologies from 1992-2004 and has run his family office since. I've taken the liberty of recreating a simple version of what Dr. Frey presented.


What determines success in investing? The answer depends on one's perspective. Without a robust understanding of market history, one's perspective tends to be their own (recent) experience. A historical approach tells us this is far too narrow a view.


How often is the market above or below its previous high?


This historical view shows that investor's expecting their account balances to be consistently higher this month than previous months virtually guarantees disappointment. Since 1871, the S&P 500 has been below it's previously monthly high more than 80% of the time.

(S&P 500 total return, Shiller data)


There has not been a single decade where the market spent more time (in months) not in a drawdown state than in a drawdown state.


But that's the overall market. What about the best companies?


Over a longer period - say 20+ years - we know the return on a given stock will converge to the company's returns on capital multiplied by its ability to reinvest.* But it's not a smooth ride. We did a quick look at four of the most successful stocks over the past 30 years - Berkshire Hathaway, Adobe, Fastenal, and Amazon. (And we only looked at these four of our favorite companies!)


From March 1, 1980 to March 1, 2019, over 39 years, Berkshire Hathaway produced a 20% compound annual growth rate (CAGR). Adobe (ADBE) generated a 28% annualized return over 32.6 years. Fastenal (FAST), 24% annualized over 31.6 years. And Amazon (AMZN) came in at an astounding 38% over just under 22 years. (See charts below.)


Yet, the striking similarity is that each of these incredible performers spent more than 70% of the time below their previous high. In other words, their prices were, on average, lower than they had been seven out of every 10 months.


The implications are very important for long-term investors, as Dr. Frey has stated. Most importantly, we should buy great companies at good prices. But we cannot just buy great companies... we must also hold them through time - through all the day-to-day noise of the market pundits and forecasters.


This is hard to do in real time and we do not want to make it sound easy. However, it's important to keep perspective - patience is the price to pay for long-term performance.





*A firm's sustainable growth rate is equal to the firm's Return on Incrementally Invested Capital x Reinvestment Rate.

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