Why is This Drawdown so Painful?
The reason you're seeing so many individual investors hurting online
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I was on a podcast! Alpha Bets was kind enough to have me on to talk about Corsair last week. It was a great conversation and I highly recommend checking it out! Seriously, Nathan, Pat, and Ross were all awesome.
Disclaimer: This and all posts on Theta Thoughts are my thoughts alone and should not be constituted as investment advice
I want to start this week by thanking everyone for supporting me through the first month of this writing journey! A month in and we’re at six written pieces totaling over 12,000 words with nearly 75 subscribers to the newsletter! From the bottom of my heart, thank you. It humbles me to know that people find my work worth a few minutes of their week.
This week’s piece is a bit off the rip since I normally write about my research into companies, but I’m starting college again while having to move over three hours from home this week, so I haven’t been able to go as far into a new project as I would’ve liked before writing a piece. Instead, I’ll be sharing some thoughts on why the recent drawdown has been so painful for individual investors. No, I’m not going to go all macro furu to tell you why stocks are down or show you technical analysis like every finance influencer, and we’ll be hopefully back to our regularly scheduled programming by next week once I’m settled back in at my college apartment. Anyways, onto the show.
The Retail Trader is Hurting
Suffice to say, it hasn’t been a smooth start to the year for the markets. Despite a rally in futures as I’m writing on Sunday night, (I had to take out my sadness at the Bills losing somehow), stocks have taken an absolute beating during the first three weeks of 2022. The Dow is down over 5.5% to out of the gate as the leader of the major indices, and the others are faring far worse. The S&P is down about 7.75% and the Nasdaq and Russel 2000 are both down almost 11.5% just this year!
To be clear, corrections in the market are normal. They happen often historically and are healthy. But you may have noticed that there’s much more pain from individuals this time around. Not just from your WallStreetBets besties that have this to say,
but also from people that aren’t actively choosing to donate their savings to the investing department at Goldman. It’s all over my feeds, and I’m sure it’s all over yours too. Which begs the question, why is this under 10% decline in the S&P 500 causing so much pain? The answer boils down to two things. Exposure/allocation and psychology.
Exposure/Allocation (The How)
I’ll get the most important reason out of the way first as it’s the how as to the pain out there right now. It’s simply exposure and allocation. People that have been responsibly indexing and dollar-cost averaging for years need not apply since they probably haven’t even noticed anything has happened. However, most people that are new to independently managing haven’t adopted the same appetite of putting some of their paychecks into VOO and leaving it alone. People are picking their own stocks that they think will generate high returns at an increasing rate. And that leads to the quintessential problem in this decline. Individual investors are underweight mega-cap stocks when compared to the major indices.
This partly relates to the last part about psychology, but when an individual is trying to beat the market, they often will shy away from the largest names because they think they have to outperform those names. That leads to a problem though, since having mega-caps as an underweight position compared to the index is effectively betting that those mega-cap companies will underperform compared to a benchmark. It’s essentially having a net short position if you think about it like that.
As is blatantly obvious from this chart, the largest names in the index, the Nasdaq in this case but it’s the same for the S&P, have outperformed all other stocks by a wide margin. Since the peak in speculative stocks in February of last year, the five largest Nasdaq stocks outperformed the rest of the index by almost 40%. While smaller names were getting crushed late in 2021, Apple surged 20% to new highs, helping keep indexes up but not relieving the pain of individual stock pickers.
While there has been some minor mean reversion in the past week as selling has become more widespread, (I’m looking at you Amazon and Netflix), this performance gap between mega-caps and the rest is the primary reason why people are hurting so much. Under the hood, individual stock performance is just far worse than the 14% decline in the Nasdaq or the 19% decline in the Russel 2000 since hitting recent highs.
More than 36% of the stocks in the index are down at least 50% from their 52-week highs, an extraordinarily large number given the scale of the overall index’s drop, according to Ned Davis Research. Typically when the Nasdaq is within 10% of its peak, an average of just 12.5% of its stocks have declined that much, the firm said. (Bloomberg) on January 14th, 2022
The Bloomberg quote and the showing of Russel 3000 breadth perfectly capture this issue. And keep in mind the Russel 3000 data is over a month old. That index has fallen over 7% since, exasperating the reality of smaller-cap underperformance. This is only compounded by the fact that individual investors tend to be overweight growth/tech to value companies. I love cash flow, but I guess there were too many Twitter memes about value bros getting dunked on for people to take the value path. With small-cap value outperforming growth by 30% in just the past year, they’re probably regretting that and jumping ship to talk about shale and oil stocks like everyone is online.
Psychology (The Why)
Despite poor decisions by retail in choosing exposure, you’d think people would be used to heightened volatility at this point. After all the surge of retailer investors are people that are used to getting rug-pulled on altcoins and NFTs. But when it comes to stocks, this cohort of stock-pickers has never seen such an event unfold. They weren’t actively in the markets during Volmageddon or the Fall of 2018 Bear. The vast majority weren’t even active during the Covid crash at the start of 2020. The reality is that new investors have never been in a period of serious and sustained market decline.
Yes, short-term declines like the tech correction in the fall of 2020 or interest rate fears last February/March have occurred in the lifetime of these investors, but they’ve never seen a period of sustained drops in their stocks of 20%, 30%, or even 40% or more. It’s especially startling to these investors when considering their expected return has been dramatically skewed to the upside. At this point, it can easily be considered an unrealistic expectation of the future.
It certainly doesn’t help that a massive amount of the companies these people are invested in have no cash flow and run losses despite their still arguably obscene valuations. Either way, seeing such losses is a constant gut punch, even for professionals.
When someone sees so much of their money vanish, fear tends to take hold. You lose sleep, worry constantly about whether you’re making the right choices. It’s truly difficult to stomach. You hear the greats talk about it often, but that’s why so many people are in pain right now. They’ve never experienced any drawdown of this magnitude and simultaneously were expecting higher returns. That can be scary for individuals, especially when considering that misconceptions about risk may lead to people putting more money than they’d be comfortable losing if they knew the real risk level.
So, if you were looking for some reason as to why people invested in the market are in so much pain right now, there’s my take that I’ve written on a Sunday night crying over NFL overtime rules. For all I know the bottom already happened if the Fed becomes even slightly dovish this week, so inverse whatever I’m writing about if you know what’s good for the world.
Anyways, I have class in under 8 hours from when I’m writing this so I’m going to call it here for the week. Thank you again for supporting me through my first month of writing, I hope to keep putting out high-quality work to the best of my ability throughout this year. On a real note, for my more serious pieces, please feel free to reach out with feedback and constructive criticism. I’m not just writing to provide research but to also learn and improve along the way. I’m sure there are people far smarter than myself with much more experience coming across these, and I’d love to hear everyone’s thoughts on how I can make what I’m doing even better.
Have a great week!