Certain Uncertainty - Control what you can Control and Moving into Cash - Part 3 of 5

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Moving into Cash - the Unknowable and Uncontrollable bits
In Part 2 of this Blog Series I wrote about what kinds of things are ’Controllable and Knowable’ when it comes to Moving into Cash but the ‘Uncontrollable’ and ‘Unknowable’ aspects of Moving into Cash are many and by definition impossible to be certain about in advance. The kinds of things that are Uncontrollable and Unknowable include factors like the following:

• How big an expected Market Sell-off will be.
• Whether or not such an expected Market Sell-off will actually happen.
• The ‘Speed’ of the drop in terms of the time from starting the Drop to it finishing (Peak to Trough).
• The ‘Speed’ of a Rebound (this time Trough to Peak).
• When the Market is falling, the degree to which you are psychologically able to withstand the immense pressure that seeing your Portfolio get battered day after day can bring (it is no good panicking at the Bottom and selling out just before the Rebound - you would be amazed how many People do this - I have done it myself many times over the years despite my best attempts to avoid it). This psychological pressure is amplified if you use Leverage via Spreadbets and/or CFDs etc. (Contracts for Difference).
• Whether or not the Diversification across your Stocks is able to withstand the battering to a satisfactory degree.
• Exactly where the Peak and Trough actually are - such Turning Points are a lot easier to spot long after they have happened than either as they are happening (pretty much impossible) or a bit after they have occurred. This is crucial because your success when it comes to a ‘Moving into Cash’ Strategy depends hugely on Selling just as the Market comes off the Peak and buying back in just as the Market comes up off the Bottom. The closer you are to these Turning Points the more successful your ‘Moving into Cash’ Strategy will have been. However, ‘V’ shaped Recoveries are very rare and most times a ‘Bottom’ starts to form up over time and this makes it a lot easier to time the moment to buy back in.
• Etc.

Due to the Uncertainty and Unknowability of these Factors in advance, by definition we cannot work out a Value for each of these and therefore get precise impacts. I guess if you are some sort of Maths Genius (that’ll be you then, Callum !!), you can create a whizzy Mathematical Model which uses Probabilities to put Values on these things but in practice that is obviously extremely hard to do for most Regular Numpties and of course it is a huge amount of effort to produce something with limited practical use anyway !!

However, there is another way to do this more simply (you know me, if there is a Simple Way I always like it !!) and rather than working out the Value Impacts of each Uncertain and Unknowable Item (er, that does sound a tad difficult anyway !!) - we can just use an Aggregate or Total Figure.

In other words, all we need to do is think about what kind of Market Drawdown we are most likely to see (remember, when I am talking about ‘Moving into Cash‘ here it is very much in the context of anticipating Sizeable Falls in the Market in General, rather than Falls on Individual Stocks due to their own specific factors - the Diversification within your Portfolio is to help reduce the Risk from such Stock specific factors and it assists in this respect at all times, not just when Markets are generally pants). Now again this is quite an exercise in itself but it is certainly not beyond the simple guessing capabilities of any Market Participant with at least a few fully-functioning Brain Cells. What I am getting at is that we can look at what has happened to Markets in the past and then use our Best Guess with regards to what we expect to happen in any Potential Market Drop in the future - and we don’t even need to be that accurate because we can do ‘Scenario Planning’ where for instance we create a Simple Model for perhaps a 10% Drop or a 15% Drop or a 20% Drop etc. - and then we can make Decisions about ‘Moving into Cash’ based on these Scenarios (later in this Blog Series I do a section on a Model which involves using Probability methods to judge the extent of a likely Drop).

Using our earlier Portfolio worth £250k (this was in Part 2 of this Blog Series), let’s create some Model Scenarios for a few Potential Market Drops. For the purposes of this exercise I will use the 2% Spread Number simply because it will scare you more !! (obviously Readers can re-work a similar exercise themselves and play around with the input parameters - if you are really razor sharp in the Brainbox then you can probably use a Spreadsheet to do this). In addition, I will merely assume at this point that the Portfolio tracks the Overall Market precisely and therefore a 10% Fall in the Markets means your Portfolio drops 10% (of course in practice this is unrealistic but Readers can run the Numbers themselves depending on how their Portfolio tends to behave (when you have been doing this game for a while you get a sense of the kind of Drops your Portfolio suffers when the Bears come calling. For myself, I have a lot of Stocks of varying sizes and to a large extent my Portfolio does track the Market quite closely. If you only hold perhaps 15 Stocks or less, then you might find that your Portfolio behaves very differently to the Market but it will still most likely Fall and Rise with the Market but it is the degree of the move that will differ). 

For the purposes of these Scenarios, I will also assume that the Market rebounds and gets back to its Previous Level before the Falls - obviously Readers can make their own Decisions/Assumptions about my Models but this is more to introduce the Principle than to get precise Mathematical Models that fit all circumstances. I will also assume that the Drop is Short and Sweet and that a Rebound comes pretty quickly so the affect of Dividends Foregone is minimal. My examples also assume that you are ‘The Best Trader on the Planet’ - well in the Universe in fact !!

I will go through some different Scenarios and try to figure out what the impact on a £250k Portfolio would be.

A 10% Drop in the Markets which then Recovers in reasonable time

• If you do no Selling before the Drop, this would mean that your Portfolio of £250k drops by £25k from the Peak to the Trough before it then turns up again if you do absolutely nothing. You have no Costs from Selling and Buying back and your Portfolio is still worth £250k at the end of the Scenario.
• If you Sell 20 out of your 40 Stocks but do no Buying at the Bottom, then the drop on your Portfolio would be £12.5k before it turns up again, but you will have Certain Costs of £3400 minus £200 because you do not yet have the Dealing Fees to Buy back (so £3200 total). Therefore, after the Recovery, your Portfolio will be worth £246,800 - this would consist of Stocks worth £125k and Cash worth £121,800.
• If you Sell 20 out of your 40 Stocks at the Top and then Buy back right at the Bottom with the Cash you have, then after the Drop and Rebound, your Portfolio will be worth £260,350. To work this out, the Half of your Portfolio that you kept in Shares will have dropped by £12.5k but then rebounded to be worth £125k afterwards. However, the £125k you moved into Cash keeps its Value when the Market falls and then if you Buy right at the Bottom, it adds £13,750 of Value on the Bounce less the £3400 Costs - so that is £10,350. The Maths here is much more complicated than it seems. When the Market drops 10% from its Starting Point, it then has to Rebound 11% to get back to the Starting Point - so the Cash you Buy back in with at the bottom does better than you might initially think. So at the end you have the Initial Shares worth £125k plus Shares you bought at the bottom for £125k plus £10,350 of added Value.

As an aside, to work this last bit out, if you imagine you start with 100 and then get a Drop of 13%, at the end you would have 87. Now to get 87 back to 100 it needs to grow by about 15% - you work this out by the Sum 100 - 87 = 13, then 13 divided by 87 = 15. So 87 multiplied by 115 gets you back to 100.

It’s a bit like the fairly well known saying where “If a Stock falls 50%, it then needs to grow 100% to get back to where it started”.

A 15% Drop in the Markets which then Recovers in reasonable time

• This would mean that your Portfolio of £250k drops by £37.5k from the Peak to the Trough before it then turns up again if you do absolutely nothing. You have no Costs from Selling and Buying back and your Portfolio Value is back at £250k.
• If you Sell 20 out of your 40 Stocks then the drop on your Portfolio would be £18.75k before it turns up again, but you will have Certain Costs of £3400 minus £200 because you have not bought the Shares back yet (so £3200 total). So after the Recovery your Portfolio would be worth £246,800 which would consist of Stocks worth £125k and Cash worth £121,800.
• If you Sell 20 out of your 40 Stocks at the Top and then Buy back right at the Bottom with the Cash you have, then after the Drop and Rebound, your Portfolio would be worth £261,300. To work this out, the Half of your Portfolio that you kept in Shares will have dropped by £18,750k but then rebounded to be worth £125k afterwards. However, the £125k you moved into Cash keeps its Value when the Market falls and then if you Buy right at the Bottom, it adds £14,700 of Value on the Bounce less the £3400 Costs - so that is £11300. The Maths here is much more complicated than it seems. When the Market drops 15% from its Starting Point, it then has to Rebound 17.6% to get back to the Starting Point - so the Cash you Buy back in with at the bottom does better than you might initially think. So at the end you have the Initial Shares worth £125k plus Shares you bought at the bottom for £125k plus £11,300 of added Value.

A 20% Drop in the Markets which then Recovers in reasonable time

• This would mean that your Portfolio of £250k drops by £50k from the Peak to the Trough before it then turns up again if you do absolutely nothing. You have no Costs from Selling and Buying back and your Portfolio is worth £250k after the Drop and Rebound.
• If you Sell 20 out of your 40 Stocks then the drop on your Portfolio would be £25k before it turns up again, but you will have Certain Costs of £3400 minus £200 because you have not bought the Shares back yet (so £3200 total). So after the Recovery your Portfolio would be worth £246,800 which would consist of Stocks worth £125k and Cash worth £121,800.
• If you Sell 20 out of your 40 Stocks at the Top and then Buy back right at the Bottom with the Cash you have, then after the Drop and Rebound, your Portfolio would be worth £262,225. To work this out, the Half of your Portfolio that you kept in Shares will have dropped by £25k but then rebounded to be worth £125k afterwards. However, the £125k you moved into Cash keeps its Value when the Market falls and then if you Buy right at the Bottom, it adds £15,625 of Value on the Bounce less the £3400 Costs - so that is £12,225. The Maths here is much more complicated than it seems. When the Market drops 20% from its Starting Point, it then has to Rebound 25% to get back to the Starting Point - so the Cash you Buy back in with at the bottom does better than you might initially think. So at the end you have the Initial Shares worth £125k plus Shares you bought at the bottom for £125k plus £12,225 of added Value.

A 10% Drop is fairly typical in a Sell-off I would say unless we are going into a full-on Bear Market like in 2008 and 2001 etc.

What I do notice from these Examples is that Moving Half your Portfolio into Cash seems to have clear Benefits in that the ‘Drawdown’ as the Market Falls is much reduced than if you keep your Portfolio intact and the Rebound boosts your Portfolio a lot if you Buy exactly at the Bottom (I am sure you can see the flaw here !!). 

What does hit me though, is that on a Portfolio of this Size if you do Buy back at the Bottom,  there is not really all that much difference between whether it is a 10% or 15% or 20% Drop and Rebound - that actually surprised me a bit. My Conclusion from this is that the Costs do eat into the Return a fair bit. To clarify, the Total Numbers after the Drop and Rebound for 10%, 15%, 20% in these Example Scenarios are £260,350, £261,300, £262,225.

However, on the evidence here (which is clearly flawed in many ways and mostly due to practicalities and I will try to address this a bit in Part 4), it does look like it would be worthwhile to Sell half your Portfolio before a big Sell-off and to buy back at the Bottom.

That’s it for Part 3 - I hope your Brain hasn’t exploded and made a mess on your Keyboard.

Cheers, WD.

P.S. You might not have seen that @Conkers3 and myself recorded another TwinPetesInvesting Podcast a few days ago and we’re really pleased with the feedback on it. You can find it here and I recommend you give it a listen:

https://soundcloud.com/user-479955511/wheeliedealer-and-conkers3-discuss-the-stock-market-sell-off-taking-profits-mellolondon-more