What has been notable about 2021 is the volatility that has been witnessed in many growth stocks and growth themes. It has not been uncommon to see 20-50% pullbacks in certain stocks. The reasons for the deep drawdowns have varied and include, missed earnings, missed guidance, initiation of ‘short’ reports, sector rotations, and threats of new regulations. After such drops, we often have readers reach out and ask our opinion on how to trade and manage a position that appears to have fallen off a cliff. The immediate inclination is to either run for the exits or to buy more. Below are three of our personal ‘best practices’ and ‘tips’ that may assist readers when they are faced with this dilemma.
3 Day Rule
If you plan to buy more and average down, we try our best to wait 3 days before adding to the position. Sudden drops in stock prices can trigger margin calls that can cause more selling the next day. This can be exacerbated by institutional investors who have decided to exit but do not typically dump all their shares at once. Rather, they may take the next couple of days to unwind. And finally, investors who engage in options contracts after a sharp drop will not have their orders settle until the next day and this can further drive volatility beyond the first day. As enticing as it may be to jump into a stock that had once been too expensive, it would also be prudent to give oneself 3 days to reflect on whether the reason for the drop is signaling a change in the corporate fundamentals.
Wider Scales
Prior to the sudden pullback, if a stock had already been trending lower and you have already added to your position at higher levels, we would recommend buying with wider scales. This entails adding to your position incrementally after every 5-10% drop from your last purchase. Monitoring and working within your target position size is key to this approach. This helps investors to keep disciplined and prevents them from using all their ‘dry powder’ in what could be just the start of further declines. At some point, we have all yelled at the market and attempted to take a stand by committing new capital aggressively, only to realize the market doesn’t care what we think!
Taking Profits
Some investors have the fortune of owning big winners that have more than doubled in price. Sometimes, owning a stock with a 100% gain has led investors to feel that they have built enough of a cushion and they become apathetic to pullbacks in the stock. As illustrated below, investors should not get too lax as seemingly mundane pullbacks can erode your gains exponentially.
We have met with investors who incorrectly presumed that a 100% gain followed by a 30% loss would still leave them with 70% gains. This still seems like an outsized gain which may lead them to ignore the drop. However, as one can see, the actual return has eroded to ‘only’ a 40% gain. This is still a successful investment, however, equipped with the realization of how fast gains can be given up, investors tend to change their overconfident approach. This is not to say that investors should always take all their profits and run. For those positions that are considered a longer-term core holding, we feel it is prudent to trim 25% of the position every time it doubles. This allows further compounding on the principal and the majority of the gains. For those positions that are not seen as core holdings, we find it prudent to take back your principal after the first double. From there, without any original principal at risk, investors can compound their gains and decide to take 25-50% on subsequent doubles.
Ultimately, an investor’s suitability, risk tolerance, and time horizon should be the chief considerations when investing in higher growth sectors and themes. The above are certain best practices that investors can consider when managing volatile names. Getting a second opinion and working with your advisor to assist in rebalancing positions can further lead to fewer negative surprises.