If we look at the stock market, we notice that no one knows the future. There are surprises.
We have also observed that the surprise makes sense once you know more. Another situation is added to the inventory of decision tools and we move on. In the long run all the noise disappears and the fundamentals dominate.
Certainty is too costly to acquire.
Our problem is we don’t like to wait. “Lord, give me patience – RIGHT NOW” seems to be the prayer. Patience is easier if we recognize urgency has costs. We should investigate when and how an urgent response has value.
Deep in our brain we have responses to urgency that at one time kept us alive. As our civilizations changed, they became less relevant. A Bengal tiger in your yard is not the same thing as your favourite stock dropped 10%, yet our physical response is similar.
When urgency seems present, we produce an adrenaline response, – Fight or Flight. Our response to something that frightens us, but is not susceptible to fight or flight is less well developed. There is no live or die advantage to acting immediately on bad investment news, although our body’s endocrine system says there is.
The response to it should be different too. Understand the difference and what it means to you.
Our reasonable response, after counting to ten or a thousand, should be “Let’s understand what happened here then decide the best course of action to optimize the future.” Emphasis on future. What would a Martian do? The Martian would not know the history so would be 100% future focussed. You should too. How it came to be is information for future decisions. It won’t change this event.
Consider consequence. If your life is unaffected by the change, there should be little urgency. Like your house value. If that value goes up or down 15%, it is still the same house.
Is it just this stock or is it system wide? It’s easier if it is system wide. Perhaps your stock has just gotten caught up in the emotional response to a falling index. Your stock might not even be in the index. Your emotional response to other people’s emotional responses tends not to be right.
Has it happened before and if so, what happened then? We know markets rise slowly but fall quickly. The fall is usually over done. The fear emotion is a powerful motivator. Objectively, it might be a time buy instead of sell.
Are the present case and the earlier example we found based on similar information? Maybe the stock falls sharply when a CEO moves on, or the price of a raw material changes, or some tax situation is adverse. Maybe a patent lawsuit is lost. There are many things that contribute to a sharp drop for a single stock. Most of them involve things that have not yet been contextualized.
If there is nothing similar in the past for this stock, are there others whose study would be useful? Yours is not the only business that has seen a drop. What, if anything, is similar?
Almost always there is not, so there is risk in whatever you decide. Revisit your original decision basis. What is different? Is the business fundamentally the same but the market has mispriced it, or is there a serious change in the fundamentals? Maybe the macro market fundamentals are different. What if the Fed moved interest rates up 3%?
What is the tendency for price in this situation? If stocks tend to go back towards fundamental value, then you could expect it to happen again. That’s where certainty comes in. How sure do you need to be to let it ride?
Let’s not kid ourselves, there is no certainty in the stock market. It is about tradeoffs, much like everything else in life. You tend to get higher yields over the long run if you accept some short-term volatility. No guarantee but history speaks clearly on this point. The tradeoff you make is in deciding how much extra volatility will you accept?
Andy Martin, @dollarlogic, posted this on Twitter recently. The box at the top includes his view and yours may be different. The idea is you always make tradeoffs between short term predictability and long term yield. There is no right answer that suits all of us, so we must know ourselves before addressing the portfolio question.
When we know there is a very dramatic possibility of short term loss and a clear tendency to long term gain, how should you respond?
There is no easy answer for a particular security but for the market as a whole, you would have to think the economy had failed to make a quick exit the right answer.
There is no certainty, but there are tendencies.
“The race is not always to the swift nor the battle to the strong, but that’s the way to bet” Damon Runyon
In the stock market, waiting until you are sure means you buy too late. How sure must you be to execute a trade. If very sure, the stock market is likely going to be uncomfortable for you.
The question you should ask is “How big must the signal be for me to act?”
The signal quality changes as information is found. A single data point is not very useful, but if you can find, evaluate, and understand six factors pointing up and two pointing down, how sure do you need to be about any of them. The nice thing about the market is you can change your mind, although not without cost.
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