I had an entirely different column in mind for today. But the events of last week were so peculiar, and so revealing of another classic investor foible, that I shifted gears.This will be one of the few Apprenticed Investor columns written in response to current events. I'm doing so because I feel it's necessary to address last week's topsy-turvy market action. More specifically, the investor reaction to it. A brief background: In my day job, I advise institutional investors on the state of the markets. When risk, according to my metrics, has risen unacceptably relative to reward, I become cautious. When the reverse happens, I get more aggressive. This has been my style for some time, and it works for me. Once I explain the process, I'll lay out the mistakes the public makes in reaction to these market calls.
'Are You a Bull or a Bear?'I've heard this question countless times the past few weeks. And I find it a stunning rejection of Darwinian logic that proponents of such blather have managed to evade extinction. Investors simply never get asked a more distracting and pointless question. Effective investors find their style, then read the market and adapt accordingly. Of course, in discussions about Wall Street, the bull and bear are mesmerizing. How often do we hear a newscaster somberly intoning: "The bears got gored by the bulls on Wall Street today..." The very next day, we hear the same talking head reverse course: "On Wall Street, the bears came out of their caves to chase the bulls, as the Dow dropped..." The markets we saw last Wednesday and Thursday are textbook examples of why the colorful imagery of the bulls and bears is magnetically attractive to copywriters and repellent to good investing. Why is this such a problem? Because of the "folly of forecasting": Once people commit to a position, there is an unfortunate tendency to root for that perspective. Even worse, people stick with their forecast, regardless of what is actually happening in the market. We addressed this in the very first Apprenticed Investor,
Bull and Bear, a Matched PairIn a firm I worked at during the bubble years, many of the brokers had bulls on their desks, but no bears. I used to take away their bulls, and refuse to return them unless they promised to display the bear also. I did this to prove a point: There are two sides to every market. If you ever meet a money manager/broker/financial adviser who only has bulls displayed, run -- don't walk -- to the nearest exit. Why? Because it reveals a fundamental lack of market understanding: Markets go up and down; the bull and the bear each have their day. And that's why the bull or bear question is inane. Stockholders should be watching market signals, economic issues and corporate earnings, with an eye toward adjusting their risk profile and investing outlook. Why? Because just like markets, risk goes up and down also. But once an investor commits to the bull/bear question, it leads to the unfortunate tendency to cheerlead for their last call rather than focusing on protecting capital. This very quickly can become an expensive hobby.
Red or Green: A Case StudyHere's a hypothetical example: Let's say you have a few errands to run that will require your driving a car. Before you turn the key, decide the following: Are you a "red" or a "green?" You have to be something, so pick one before you leave the garage. Now, apply that choice at every signal you hit on your errand. If you're a red, come to a dead stop at every signal. If you are a green, just drive through the next red light. When the cop asks why, just tell him it's because you are a "green." (Good luck in court). Clearly, this is absurd. Rational people observe the color of the light, and step on the brake or accelerator as appropriate. Yet when it comes to the markets, many otherwise rational people do just this. They have predetermined their intentions and invested their dollars -- regardless of the many signals the broader market gives. One need look no further than recent history to see that ignoring market signals is a recipe for disaster.
|1.||Expect to Be Wrong||2.||Your Fault, Reader|
|3.||The Wrong Crowd||4.||Bull or Bear? Neither|
|Check back for more of Barry Ritholtz's |
Apprenticed Investor series