Please Stay Seated While the Train is Moving

On August 6, 2011, Standard & Poor’s downgraded the United States credit rating from AAA to AA+, kicking off a very turbulent week for the markets. I wrote the article below at the end of that week, but didn’t have a place to publish it at the time. While the last few days’ volatility hasn’t compared in magnitude to that week in 2011 or a few others I can think of in 2008 during the financial crisis of (there are weeks referred to by names such as “Lehman Week”, or “Bear Sterns Week” that come to mind), it has brought back a sense of risk amongst investors that caused me to dust this off and post it.

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The market last week (August 7 through August 12, 2011) tested even the toughest of iron-willed market veterans. We saw four straight days of 400 point losses and gains in the first four days of the week, with each day essentially undoing the market’s action of the previous day. Many of the biggest moves took place in a matter of minutes. On Tuesday, the market showed a partial recovery from Monday’s huge downswing through mid-day. When the Federal Reserve Open Market Committee released its commentary on the economy, the market reversed course, giving up its gains and showing a continuation of Monday’s losses. Then, in the last hour of trading, the market changed direction again, surging during a frantic final hour of trading to post a gain of almost 4% for the day. Then Wednesday, the pain returned and all those gains proved fleeting.

It has long been argued that market timing – holding cash and then buying stock, seeking quick gains, then selling prior to the market reversing course – is nearly impossible to do consistently, and that on any given day the market’s action is random. There are reams of data and practical experience to back this up (see Graham & Harvey for one of the most famous studies or Burton Malkiel’s classic book “A Random Walk Down Wall Street”). Yet many investors still believe they can beat the markets through market timing, relying on CNBC or Bloomberg or some other source to provide them with an edge. I’ve long suspected that these notions aren’t based on any practical trading experience, but rather on a trick of psychology: Looking back after a change in the market’s mood, it is very easy to convince ourselves that the change – good or bad – was inevitable, obvious, and easily forecasted.

But let’s forget psychology for a minute. Let’s forget about piles of data showing that over time, frequent traders generally underperform index funds. Just think about what went on early last week… is there anyone that can claim any of those moves were obvious? If you acted on what you thought was obvious on Tuesday morning, you would have been wrong by 2:15 pm, and if you acted then on what seemed obvious, you would have been even more wrong by 4:00pm. But then the next morning’s open started the chaos all over again anyway.

The point is that trying to trade with any degree of certainty when the market is seeing this much volatility is impossible. Stay seated while the train is moving, and make portfolio moves based on your long-term goals rather than your guess at market direction. We can’t let the gyrations of a crazy week – or a month or a year – interrupt carefully made financial plans and portfolio designs.

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