How to handle stock market crashes
I must confess.
I used the word ‘crashes’ in the title even though I do not view the current stock market condition as a crash.
The purpose was to sensationalise it to get your attention.
I think these few weeks have been miserable for stock investors and some may have believed this is a crash.
The downturn was pretty much unexpected as we crossed over the new year. But there will be some smarty pants who would boast about their ‘accurate’ predictions, which they have been calling an impending crash since 2010. Just keep calling it and one day you will be right.
Prediction Eases Your Anxiety About Uncertainty, It Doesn’t Increase Your Profitability
Are crashes predictable?
Efficient Market Hypothesis (EMH) said that stock prices reflect all known information and there is no way for someone to make more money than the overall stock market returns consistently. While I do not agree in its absolute form, I believe EMH holds true most of the time.
There are two drivers of stock prices – expected and unexpected returns. Expected returns are closely tied to EMH whereby all information are known and reflected in the stock market.
Nassim Taleb coined the now-famous term, ‘Black Swan’, which explained the unexpected part. Too many investors have been concentrating on expected returns, using known information to predict stock prices, which they are just running circles within EMH. What is going to give above average returns is actually taking a position to harness the unexpected returns.
You must be asking ‘how’?
The general principle is that you must be doing things different from a crowd, using a strategy that most investors would find uncomfortable executing it. If you run the strategy through others, most of them will have a lot of critique about your strategy because intuitively it doesn’t sound right.
For example, when we talk about small cap stocks which have low volume and liquidity, plus a dead stock price, most people will snide it. Precisely nobody could know in advance what are the catalysts to unlock the value so it operates in the don’t know-don’t know domain with the potential of unexpected returns.
I get this scenario often – Someone would ask, “why do you buy this stock?”
“It is undervalued,” I said.
“But undervalued doesn’t mean it would go up. I mean the price looks dead and it is not going anywhere. I won’t want to get stuck in this. Is there something brewing behind the stock?”, someone asked again.
“I only know it needs a catalyst to unlock the value, but I don’t know when and I don’t know what it is.” I replied.
Most, if not all, will be puzzled or even be pissed with my answers.
It isn’t easy to position your investments to profit from the don’t know-don’t know domain. Most investors prefer to invest in stocks which have obvious reasons to own it. If it is obvious to you, it is safe to assume it is obvious to others. Which means the stock price have factored the reasons.
And do not predict, because how can you know what you don’t know that you don’t know about?
You Need An Approach To Anchor Yourself
Most investors do not have a well-defined investment approach. Their investment decisions rely on gut feel, tips and rumours. When the stock market turned down, their gut feel turned rotten and confidence wavered. They are not sure what to do. Buy more, hold or sell?
A well thought out approach will come in handy to anchor you when other investors are emotionally swayed by the fear in the stock market. I couldn’t stress this enough.
Think of it like a checklist; a set of rules to guide your investment decisions. Without a checklist, it is easy to go astray. Professionals like pilots, doctors and engineers use checklists. Why shouldn’t an investor do too?
Every time you need to make a buy, hold or sell decision, refer to the checklist no matter how seasoned you are. Even seasoned investors may missed out certain steps at times and make investment decisions that deviated from their principles.
Conviction In Your Investment Approach
The next problem investors face is the lack of conviction in their investment approach. This links to the previous point. Due to the lack of a well-defined approach, the investors do not have the confidence when the market turned against their positions.
Having a checklist based on sound principles is a must. An investor must have the basic knowledge about investment and researched sufficiently to build a checklist. The effort and time spent on learning and building the checklist will grow his confidence.
Before conviction, there is commitment. The investor must be committed to learn and establish his set of investment criteria. Committed to put in the effort and take things in his own hands.
And it doesn’t stop.
Because the investment checklist needs to be reviewed and refined continuously.
Know That Shit Happens
Having a investment checklist does not help the investor avoid stock market crashes. The checklist guides the right behaviour, to buy low and sell high, and prevent you from making the mistake of buying high and selling low.
Stock market will crash and it is just a matter of when. Hence it is important to be prepared for it mentally.
The feelings of going through a stock market crash cannot be explained in words. It is akin to explaining your feelings on a roller coaster to a person who has not been on one all his life. He just needs to experience it.
Even though he might get scared the first time on the roller coaster, but he will stretch his tolerance as he take more rides. Similarly, treat each stock market correction or crash as an opportunity to experience and calibrate your expectations closer to these events.
As long as you are investing in the stock market, you need to accept a 50% drawdown on your portfolio value could happen. If you can accept that, you should be able to withstand the paper loss and continue to make the right investment decisions. Eventually you will reap the rewards over the longer term.
You would have noticed that all the points mentioned above are only relevant before a crash. This is because I only believe that prevention is better than cure when it comes to investment. During a crash, most investors are just looking for cures. After the crash, investors are not willing to put in the effort to change ways because prevention takes effort. The next crash comes and they look for cures again. They think the problem is with the economy, the government, the Fed, the bankers or anything else. But the problem lies in themselves.