Stock market prices fell 12% during the first week of February.  This comes after a rally of 25% during the previous thirteen months (all percentages based on movements in the S&P500 stock index). Naturally, this is of concern to investors.  But it is not necessarily a big deal.  In fact, it could be a good thing.

Based on historical stock price data compiled by economist Robert Shiller, over the past 140 years there have been twelve distinct periods (cycles) in which the stock market experienced a “drawdown” (defined as percentage drop from a prior peak to a subsequent trough) of more that 20%.  This is just short of once a decade.  The largest drawdown was the 85% collapse in stock prices from the peak in 1929 to the trough in 1932.  The average of the twelve drawdowns is 40%.  If you are going to be an equity investor, you have to be prepared for periodic declines in value.

Some investors naturally seek protection against monster price declines.  One generally accepted strategy for doing this is to reduce your allocation to stocks.  For example, if 50% of your portfolio was invested in low risk bonds and 50% in stocks, then the portfolio drawdowns would likely be about half what they would have been if you were 100% invested in stocks; and less than half if bond yields were to fall alongside declining stock prices.  Of course, the downside of a lower equity allocation is the likelihood of less long-term growth in the portfolio.

One way to attempt to mitigate downside volatility without giving up the upside is to try to time the market.  This means to be 100% invested in stocks during bull markets (when stock prices rise) and then move out of stocks into bonds when stock prices are falling.   Performed successfully, this strategy offers the possibility of giant rates of return.  Using the Shiller data, the compounded rate of return on the “perfect timing” strategy (100% invested in stocks during months during which the stock return exceeds the bond return and 100% in bonds otherwise) is about 25% per year.  At this rate, your wealth will double every three years and increase by a thousand times every 30 years.

No one is able to call the trend in the market correctly each period. However, there are options strategies that will do this for you.  Consider two such strategies.  First, hold a broadly diversified stock portfolio, say an S&P500 Index Fund, and at the start of each month buy a one-month at-the-money put option on the S&P500 futures contract.  If stocks go up during the month, you will enjoy the upside, and if stocks go down the put will protect against loss.  An equivalent strategy is to invest in a zero-risk asset, like a short-term Treasury bill, and buy at the start of each month an at-the-money call option on the S&P500 futures contract.  The problem with either of these strategies is that in today’s market the cost of the monthly put or call is about 2%; this compounds to more than 30% per year.  The cost of the options more than offsets the potential benefit.

Expert market traders often hesitate to buy options because they are perceived to be “over-priced” due to strong demand by people aiming to protect themselves.  Another way to say this is that the stock price volatility built into the option price (so-called “implied volatility”) is greater than the volatility revealed by historical movements in stocks (so-called “actual volatility”).  Rather than buying puts or calls outright, these traders may attempt to “manufacture” options by using a trading strategy in the underlying futures contract.  The nature of this trading strategy is to buy futures when prices are rising and sell futures when prices are falling.  Paradoxically, when engaged in by large numbers of traders and portfolio managers, this strategy can have the effect of enhancing actual volatility in stock prices.

Perhaps the best strategy is to establish an asset allocation based on understanding the associated drawdown risk.  In fact, thinking through how you would react if your portfolio was down 10%, 20%, 40% or more is a good exercise to help you come up with an allocation to stocks that you can live with.

How is it that a large drop in stock prices is a good thing?  Simple, they enable the acquisition of stocks at lower prices.  For portfolios in the accumulation stage (where cash inflows exceed cash withdrawals) this can be a very powerful driver of long-term return.