By: Richard A. Anderson
The financial media loves to write articles about how much money you would have if you invested $1,000 in a particular stock on a particular date. Often times the authors of these articles will reference the best performing stock of the year and trace the history back to the stock's initial public offering, or IPO.
Take Netflix as an example. If you had invested $1,000 in Netflix stock when it went public on May 23, 2002 at a price of $15 per share, your investment would now be worth about $290,000!
Another popular example is Amazon. If you had invested $1,000 in Amazon stock when it went public on May 15, 1997 at a price of $18 per share, your investment would now be worth about $1,050,000!
While you may certainly be kicking yourself for missing out on these investment opportunities, this demonstration fails to account for the price volatility of these investments. For example, Netflix had 3 drawdowns of greater than 75% and 8 drawdowns of greater than 25%. Amazon had 9 drawdowns of greater than 25% and a drawdown of 92% during the tech bubble.
Why does volatility matter?
Volatility matters for two distinct reasons. The first is mathematical. It takes a 100% increase to recover from a 50% decline. It takes a 300% increase to recover from a 75% decline.
The second reason volatility matters is behavioral. The drawdowns on single investments like individual stocks are more likely to cause investors to sell at the wrong the time. If you would have sold your shares of Netflix during one of those many double-digit drawdowns, your investment wouldn't be worth $256,000 today. In all likelihood, it would be worth a lot less because you would have sold low and bought back in after the price increased.
Source: Kwanti
While it would have been great and life changing to have made one of the investments highlighted above (and there are many more like this), it overlooks the difficulty of holding onto winning stocks. For comparison purposes, the S&P 500 has had only 1 decline of 75% or more, which came during the Great Depression. The max drawdown during the Great Recession, which had many investors panicking, was about 57%.
So, next time you see an article that laments how much money you missed out on by not investing in one of the few rock star stocks of this generation, think "would I have been able to hold onto this stock?" If that doesn't work, you could always think about how much money you didn't lose by investing in one of the hundreds of stocks that have lost money since their IPO, like Pets.com.