The High Returns with High Volatility Game
Perhaps in response to my recent tweet, I have seen some people on Twitter, include some investors that I respect and admire, suggesting that a stock you own being down 50% means you are de facto wrong. I’m going to respectfully disagree with this as a universal statement.
Specifically, based on MIT’s experience investing in long stockpicking funds through several market cycles, I believe the following:
It depends on the game you are playing
It depends on whether you are actually set up to play that game
There are some people in the market playing a very different game, where the ability to be down 50% in something and survive, or even grow stronger, confers a huge competitive advantage
What game are you playing?
I’m not arguing that being down 50% in a stock can be OK in all strategies — far from it. For example, if you are a hedge fund and own positions on a 1–3 year view, and your limited partners (LPs) expect you to earn a return and manage volatility, then yes, being down 50% in a stock is a problem. And probably for the overwhelming majority of the investment world, it is a problem.
However, I have noticed that there is a small corner of the market in which being down 50% in a stock or set of stocks is not necessarily a problem. I find this corner of the market very interesting and very profitable, so I personally spend a lot of my time there. If you own stocks with a 5+ year view, and your LPs truly buy into that, having stocks that go down a lot isn’t actually that big a deal. Everyone around the table wants exceptional long-term returns and is willing to pay the price of volatility. You see, it really depends on the game that you are playing. The game I just described, we can call the “high returns with high volatility” game. (For more on the concept of playing different games in markets, please see Morgan Housel’s excellent essay on this topic.)
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