baird logo
Sep 08, 2020 The Ashcroft Pesek Group | Baird Retirement Management

Volatility and the Missing Bullet Holes

Social Security

It’s not uncommon for friends, family or sometimes even random strangers to come up to us and ask what the markets are “going to do” in the months ahead. Now, generally, I’d say basing your investment strategy on a prediction about the market will be about as fruitful as basing your romantic decisions on a prediction from an astrologist That said, volatility is a word we have been using a lot lately, and with the election drawing near and the pandemic continuing apace, I imagine we still are in for a bumpy ride.

One of the things that’s so dangerous about volatility in the equity markets is how it can affect investor psychology. We might not always know exactly when market volatility will come, but we do know how investors tend to react – by selling underperforming assets in favor of top performers. While this might feel it makes intuitive sense, sometimes the intuitive answer isn’t the right one.

Missing Bullet Holes

In his book, How Not To Be Wrong: The Power of Mathematical Thinking, Jordan Ellenberg tells the story of Abraham Wald, a member of the Statistical Research Group supporting the Allies’ efforts during World War II. When American planes returned from military engagements, they were riddled with bullet holes. Adding armor along the planes’ exterior offered more protection from bullets – but it also added weight, making them less maneuverable. So how much armor did they need to add? And where?

The military studied the data regarding the planes returning from the battlefield and found the bullet holes were not evenly distributed throughout the plane:

Section of the Plane

Bullet Holes Per Square Foot





Fuel System


Rest of the Plane


This offered an opportunity for efficiency: If you concentrated the armor where planes are being hit the most, the military leaders reasoned, you could get the same protection with less armor. According to the chart above, that meant taking armor from the engine and moving it to the fuselage.

You can imagine their surprise when Wald and the Statistical Research Group offered an entirely different conclusion.

Wald wondered about the “missing bullet holes” – the holes missing from the engine casing. If there were an even distribution of bullet holes across the plane, there should have been holes all over the engine portion of the plane too. So where were the missing holes? The answer, Wald surmised, is those planes with bullet holes on the engine were the planes that did not come back. More armor was needed to protect the engine, not less.

Applying Counterintuitive Reasoning to Your Portfolio 

Why tell you all of this? The intuition the officers had is one shared – nearly universally – by investors. We see assets that have overperformed recently in our portfolios and immediately think, Those are performing well – I should add to those, when what we should be thinking instead are Those are performing well – I should consider selling or Maybe now is the time to add to my underperforming investments. (Of course, this is looking at investments strictly from a price/value standpoint – there’s a lot more than goes into determining when to buy or sell an individual stock.) But in a sense, we are programmed to think this way. When an asset underperforms in the short term, perhaps during periods of high volatility, investors don’t typically ask to shift some of the gains from the overperformers to the underperformers – quite the contrary. They would be much more inclined to sell the “loser” at this point in time and buy more of the “winners.” Sell low, buy high. Move the armor to where most of the bullet holes are.

But the reality is that the “winners” have by definition gotten more expensive, and buying more of them at an elevated price makes it harder to come out ahead. Conversely, the “losers” are now trading at a discount, potentially making them a more attractive buy-low option.

The same counterintuitive dynamic exists in broader portfolios too. When we break down equity portfolios into various groups, you might see something like growth, value, large cap, small cap, international, etc. By mixing assets that are not perfectly correlated, we gain broader exposure and, on average, less risk. Assets that are uncorrelated will not experience gains and losses at the same time or of the same magnitude. It is likely your portfolio will have rotating cohorts of “winners” and “losers.” If your advisor told you your portfolio had become overweight in growth and underweight in value due to market performance, you may not like the remedy – to take some of the gains from the “winner” and put it in the “loser.”

One more example: Take a macro level approach, where we look at the balance of our equity positions and our fixed income positions. Our balance of equity and fixed income can be pulled out of our desired allocation by great performance in the equity market. It is not easy to pitch a client on selling an asset that has returned 20% in order to add to a position that returned 3%, even if it brings the risk of the portfolio back into the agreed-upon range. Selling top performers just doesn’t feel good, and buying the losers feels worse. Yet it might be exactly the right decision.

Of course, this is not a one-size-fits-all piece of advice. Some winners are worth holding and some losers are worth dumping. Each piece of your portfolio requires scrutiny and periodic review, and asset location and tax implications need to be considered. However, with a portfolio of high-quality, less-than-perfectly-correlated assets, your intuition may lead you to make the same mistake the officers did. It is important to keep this perspective in mind during periods of higher volatility. Our desire to sell losers and buy winners might be magnified by the conditions of the market. It is during times like these where working alongside an advisor can add immense value. We try to facilitate good decision-making, and this often comes in the form of avoiding bad decisions when our emotions tell us they will feel good. 2020 and the early parts of 2021 at the very least are probably going to bring some volatility. It would be a good time to discuss your portfolio with an advisor to understand how your assets are allocated, and what the plan is in the event or more volatility.

Robert W. Baird & Co. Incorporated does not offer tax or legal advice, but our Financial Advisors regularly work with clients' attorneys and tax professionals to help ensure that all phases of wealth management are addressed. Past performance is no guarantee of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal.

Contact Us

To set up a meeting with a member of the
Baird Retirement Management team