One of the frustrations of being a parent is that children can’t be reasoned with.
No, you can’t have ice cream for breakfast.
I know you’re building a fort but can I have my couch cushions back?
Please stop feeding the dog my ribeyes.
With great difficulty, I’m learning that one of the keys to parenting is knowing what to let go and choosing your battles wisely. Once you give up the expectation that your children will act rationally, it becomes somewhat easier to deal with the fact that your humidor is now a treasure chest full of plastic gems, and your cigars are tree trunks floating down a Lego town “river.”
The same thing applies to the market. To the outside observer, the stock market seems relatively simple. Good news, stocks should go up. Bad news, they should go down. But if you expect this, you are setting yourself up for disappointment. Here’s a basic and important fact about the stock market: good news doesn’t necessarily move it up, and bad news doesn’t necessarily move it down.
Why doesn’t it behave rationally?
It does… just not in the way you expect.
Think of it like the world’s largest game of chess, with millions of investors jockeying their billions of pieces. You are competing against all of these people, all trying to anticipate what’s coming around the bend and to be first in (or first out).
And so it is that the casual observer or stock market hobbyist wonders why their investment went down on good news, or up on bad news.
Well, it’s because a lot of smart people may have already seen this news coming. To give you an example of how this is working, large investors can buy access to satellite and cell phone data that tracks customer activity at various retail locations. And so by the time your favorite retailer reports amazing earnings, those investors will have already made this determination, bought the stock several months ago, and will be selling their shares once the information is common knowledge.
We call this “selling on the news,” and it’s one of the most frustrating things the new investor deals with. In order for good news to move stock prices up, the news has to be better than most people expected. In a hot growth stock, that often means that there’s a ridiculously high bar to clear.
And this also applies with bad news. Especially with bad news.
It seems like an investment advisor really earns their pay when they prevent clients from selling when all the news is bad. Because here’s the thing: if the news is really bad, everybody knows it’s bad! There is no longer any point in selling, because prices should reflect how bad things are.
It’s quite uncanny how many clients reach the point of maximum pain around the same time. Often, the phones start ringing and, within days of each other, clients beg to sell everything. This always happens at the wrong time. I’ve been doing this for a quarter century through three catastrophic crashes, and you can set your watch by it. Our collective psychology is really that predictable. When the phones start ringing with clients wanting to sell it all and end the pain, you know it’s time to suck up the courage to buy.
In the business world, it’s not enough to have an idea, or see a trend. You don’t profit unless you act on it. Because of this, there are often opportunities lying in plain sight, only because others are too lazy, or they’re preoccupied, or financing is difficult to obtain. But in the investment world, there is no such friction to trading on information. Unless you are seeing something that nobody else can see, the price at which you are buying or selling usually already reflects the information leading you to buy or sell.
It can be hard for entrepreneurs to wrap their heads around this, because they have spent their careers observing and reacting, adjusting business practices, pricing, or marketing in order to maximize profits. And the switch to investing does not offer that same opportunity. If you spend all of your time reacting to developments in financial markets, you are going to churn your account to death and will never earn the returns you’re hoping for.
The multi-dimensional chess game aspect of markets simply makes it too difficult to attempt to adjust your portfolio based on what you are seeing in real time. It’s probably hard for you to accept that the best move is often to sit still. It’s not natural or comfortable. But it’s what you need to do.
The reason for this is that, even with perfect knowledge of the future, you don’t know how the market will react to different events. Nobody does. If you think you do, you’re wrong.
The way to offset the whiplash of trying to trade based on short-term data and developments is to ignore it. Focus on the long-term and ignore the noise. In this way you can move beyond the manic and illogical short-term market moves and build a long-term strategy based on sound business principles, which are far easier to comprehend and anticipate.