March 2020: Down 35% in 3 Weeks, Up Multi-fold Today

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Picture this: It's March 2020, and your portfolio is down 35% in three weeks. Your growth stocks, the ones that made you feel like a genius when the market was hot, have been obliterated.

Fast forward to today, and something interesting has happened. Your "painful" growth portfolio not only recovered but has soared to new heights.

That’s the Portfolio Pain Paradox: The investments that cause the most psychological suffering often deliver the best long-term returns.

Here are the best performing stocks of the past 40 years.

Notice how they all had eye-popping drawdowns.

After seeing this infographic, Bitcoin’s tumble of ~80% from ~$69,000 to ~$16,000 doesn’t seem that crazy, does it…

Imagine holding Apple and being down 83%, or holding Aflac and being down 84%.

Could you stomach that?

Most people couldn’t.

The Mathematics of Misery

This isn't just anecdotal, it's measurable.

There are many sophisticated metrics that quantify exactly how much psychological pain different investments inflict on their holders.

These "pain metrics" reveal an uncomfortable truth: comfort and returns are often inversely related.

3 Pain Metrics to Keep in Mind

(1) The Ulcer Index (UI)

The Ulcer Index (UI) measures both the depth and duration of portfolio drawdowns.

Named because prolonged losses literally give investors stress ulcers, it captures the cumulative psychological damage of watching your wealth evaporate.

Formula: UI = √(Σ(Percentage Drawdown²)/n)

Example: Imagine a portfolio during the 2000-2002 dot-com crash, with monthly drawdowns of: 5%, 12%, 18%, 25%, 30%, 28%, 24%, 20%, 15%, 10%, 8%, 5%

Then UI = √((25+144+324+625+900+784+576+400+225+100+64+25)/12) = 18.7%

Pain interpretation (this is subjective):

• UI < 5%: Low stress

• UI 5-10%: Manageable stress

• UI 10-20%: High stress (ulcer territory)

• UI > 20%: Extreme psychological damage

A more conservative portfolio, say 50% stocks and 50% bonds, likely has a much smaller UI, but then again, is unlikely to significantly outperform over time.

(2) The Pain Index (PI)

What it measures: Average magnitude of all underwater periods.

Formula: PI = Σ|Drawdowns| / Number of Periods

Example: Same portfolio from above:

• Pain Index = (5+12+18+25+30+28+24+20+15+10+8+5) / 12 = 200% / 12 = 16.7%

Pain interpretation (this is subjective):

• PI < 3%: Smooth sailing

• PI 3-8%: Moderate discomfort

• PI 8-15%: Significant stress

• PI > 15%: Severe emotional pain

Even "successful" growth portfolios can have high PIs.

(3) The ADD/MDD Ratio (AMR)

Formula: AMR = Average Drawdown / Maximum Drawdown

This ratio reveals the consistency of your pain versus occasional severe pain.

Low Ratio:

• Most of the time: small, manageable losses

• Occasionally: large drops

High Ratio:

• Consistently moderate losses

• No single catastrophic event, but constant bleeding

Average DD / Maximum DD can reveal your pain personality profile.

Enduring Pain and Exploiting Volatility

The relationship between pain and performance isn't coincidental, it's fundamental to how markets work. High-return investments are volatile, and that can manifest as psychological torture for their owners.

This paradox exists because markets reward investors for bearing risk, but humans are psychologically wired to avoid pain. Behavioral finance tells us that losses feel much worse than equivalent gains feel good.

This "loss aversion" makes high-return strategies psychologically unbearable for most people. This creates our opportunity.

I wholeheartedly believe that

But knowing about the Portfolio Pain Paradox isn't enough, you need strategies to exploit it.

Here are 2 ways in which we can minimize/endure the “pain” but also exploit the volatility.

(1) The Pre-Commitment Solution

The key is "pre-commitment": making decisions about how to handle pain before you experience it.

This is what I rely on most, today.

When it comes to the Coffee Can Portfolios, here are some of the "pre-commitments" we’re making to exploit market volatility.

1. We commit to owning for at least 3-5 years. 

   1. This is a contract with ourselves.

   2. It forces us to only target investment opportunities with strong long term potential, not short-term gambles.

   3. I also find that this is a great risk management technique: by expanding our time horizon, the market tends to be more forgiving.

   4. It also lets us reduce the frustration of selling too early and instead, increases the likelihood of catching more of the “right tail outcomes” simply by holding for longer.

2. We build portfolios throughout the calendar year. 

   1. I aim for 2 per year.

   2. This has 2 main benefits:

      1. It’s a good forcing function for me to minimize or avoid FOMO.

      2. Although we’re investing in individual bets, this practice of building multiple portfolios per year has a great side effect: “Dollar Cost Averaging". Since the market is auction driven, new opportunities pop up regularly.

3. We understand and exploit the math behind investments. 

   1. The most you can lose on a bet is 100% (which is highly unlikely without leverage), but you can make multiples from a winning stock.

   2. A single such victory can more than make up for several losing bets.

   3. This math works on an individual stock level, but also on a portfolio level.

   4. We focus on bets which, in aggregate, have a higher chance of making this math work out.

(2) The Tokenization Solution

Above, we rely on making decisions about how to handle pain before we experience it. But we must still adhere to these pre-commitments when the time comes. That might not be enough.

But now, with Ethereum, we can go a step further.

If we were to tokenize our bets, we could pre-configure smart contracts to make our decisions for us, without any intervention.

As a result, investors could stop getting in their own way.

For example:

1. A smart contract could be written to simply disallow any sales before a minimum time duration had passed. Investors would have no choice but to hold.

2. A smart contract could charge the investor a large fee for selling “early”. This would be a great disincentive to sell.

3. If the investment were in a Fund, imagine taking such early liquidation fees and dividing them amongsts the remaining LPs in the Fund. This would reward patience.

How cool would that be?!

You get the idea.

Smart Contracts and Tokenization have the potential to immensely help investors avoid bad emotional decisions in the stock market (and as a result improve their returns).

PS: Anyone want to build this?

In Conclusion: Embrace the Pain Paradox

The Portfolio Pain Paradox reveals an uncomfortable truth: building wealth in the stock market requires accepting serious emotional discomfort.

The investments that feel safest, CDs, savings accounts, conservative bond funds, virtually guarantee mediocre performance, long term.

The choice isn't between pain vs. no pain, it's between the temporary pain of volatility and the permanent pain of insufficient returns.

And the question isn't whether you'll experience pain, but whether you'll let that pain drive you toward better long-term outcomes or away from them..

Does this resonate with you? Let me know what you think.