Before the “PC on every desk” era, stock market analysis was mostly an art, a combination of reading market sentiment and chart patterns (books of which used to arrive in the MAIL). The gurus were wise old men who had been there, done it.
Regardless of how they subjectively interpreted events over time, they knew The Nature of Risk. And one of the biggest signs of enthusiasm was talk of a New Era — the most famous episode of which was announced by the economist Irving Fisher just before the 1929 Crash [PDF] — the crossing of a psychological barrier where fear of loss becomes fear of losing out.
The old names are still at it, but these days, we know a lot more. We can also define, quantify and compare many of the “signs” as market barometers to add to the body of work from the past:
- The Sentiment Cycle
- The Nature of Market Tops
- What is the average investor’s worst enemy?
- Propsect Theory: born to be pikers and punters
- The Driver Of Future Behavior
- Long-term capital market return assumptions
- Another one for Captain Hindsight
- Seventh son of the seventh son
Three Facts You Need to Know
I don’t expect the average investor to do the math for themselves, but there are three key facts that you must know.
First, fat tails (Black Swans or whatever you want to call them) are overwhelmingly on the left side of the curve, that is, big moves are bigger and happen more often TO THE DOWNSIDE.
For example, J.P. Morgan analysts estimate [PDF] the average loss to a hypothetical $1 billion “well-diversified” portfolio is $168 million — “in the worst five percent of cases” based on their simulation.
Not all diversification is created equal. It is very important to i.) own a number of asset classes that, in theory, are not highly correlated in price movement, and ii.) have a superior method of calculating percentages allocated to each one. We have also learned that human nature as it is, there will be times when they all freak out, and that is why we have a red alert line for those rare times.
Second, a single year’s returns (not “performance”) cannot be extrapolated into the future [PDF]; therefore, anyone who thinks it’s a good idea to put all their money into stocks because the S&P was up big in 2013 will likely regret it.
Investors who chase performance will always be locked in a cycle of buying high and selling low.
Third, disaster WILL happen again [PDF]. Guaranteed.
We shall see how the latest emerging market turbulence unfolds. One thing we know for sure, we’ve seen this all before. More discipline, less stress is how we handle it again.