Thursday, February 12, 2009

Financial Intelligence - Part XIX

Investing in the Stock Market
The above slide illustrates a very CRUCIAL aspect about investing in the stock market. When one begins to invest in the stock market, the most illusory aspect about it all is the relative sense of calm. Stock prices don't move up or down much most of the times. Instead there are long periods of boredom where it increments up and down in minute amounts. Where is the excitement and roller coaster ride I signed up for?

As Jason Zweig points out here,

Nearly all of us try forecasting the market as if each of the past returns of every year in history had been written on a separate slip of paper and tossed into a hat. Before we reach into the hat, we imagine which return we are most likely to pluck out. Because the long-term average annual gain is about 10%, we "anchor" on that number, then adjust it up or down a bit for our own bullishness or bearishness.

But the future isn't a hat full of little shredded pieces of the past. It is, instead, a whirlpool of uncertainty populated by what the trader and philosopher Nassim Nicholas Taleb calls "black swans" -- events that are hugely important, rare and unpredictable, and explicable only after the fact.

History shows that the vast majority of the time, the stock market does next to nothing. Then, when no one expects it, the market delivers a giant gain or loss -- and promptly lapses back into its usual stupor. Javier Estrada, a finance professor at IESE Business School in Barcelona, Spain, has studied the daily returns of the Dow Jones Industrial Average back to 1900. I asked him to extend his research through the end of 2008. Prof. Estrada found that if you took away the 10 best days, two-thirds of the cumulative gains produced by the Dow over the past 109 years would disappear. Conversely, had you sidestepped the market's 10 worst days, you would have tripled the actual return of the Dow.

"Although we could make a bundle of money if we could accurately predict those good and bad days," says Prof. Estrada, "the sad truth is that we're very, very unlikely to do that." The moments that made all the difference were just 0.03% of history: 10 days out of 29,694.

There may be those who are prescient with an ability to gauge exactly when those 10 days are. For the rest of us mortals, it would be better to understand the intrinsic value good companies we are interested in. Wait for those 10 days to appear and have your cash ready to swoop in on them when Mr. Market is an extremely suicidal mood.



Thanks for the feedback on Average Is Not Normal. Please let me know if you have any questions.

Damien Tan

It sounds like the Paretto principle where 20% of the action begets 80% of the results, except the case you highlighted brings it down to 3-tenths of a percent. I'd hate to be in the stock prediction business about now. Aside from a few individuals who were considered crackpots, its funny that all the tools in the world were unable to foresee the meltdown.


Dear Damien,

You're right! It's almost impossible to predict the specifics as to the stock market as well as the economy since humanity is not always rational. However, I think there were many that foresaw the trend towards the US meltdown. It was only the timing that was difficult to predict. The few supposed *crackpots* were the ones brave enough to voice these thoughts out in the open.

That's why I'm *trying* to invest in the stock market with a margin of safety. Though with the world and economy going loony, it's tough to see how this is all going to pan out.


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