The markets are complex systems; they can suddenly change. While things might be travelling along nicely, it doesn’t take much for sentiment to take an aggressive turn, the market to become pre-occupied with the negatives and all of a sudden the market is a lot lower. While investors will look back and point to ‘this reason’ or ‘that reason’ as the event blamed for the sell-off, in reality the situation is no more alarming than the negative news snippets that the market would ordinarily take in its stride.
A useful ‘mental model’ for explaining this phenomenon in the markets is the sandpile analogy; where a pile of sand develops from dropping individual grains from above. The sandpile continues to grow until a critical state is reached from which a single grain, no bigger than any of the previous grains, can bring about a collapse in the structure. It only takes one stone to start an avalanche. The real difficulty in this of course is that no one can predict which grain will be the one that triggers that avalanche.
No doubt you will have noticed that in the last couple of week or so we’ve experienced a significant spike in market volatility. Whether this volatility will continue and the markets will decline further, no-one actually knows. But what is evident is that the market moves were largely unexpected.
As more assets are held by people with zero comprehension of what they actually own, it’s no surprise volatility spiked when the unexpected happens. These investors have no idea of the underlying worth of their investments and therefore no price to anchor to. No price is too high or low for an index fund to sell or buy. And when there is fear they all try to run out the gate at the same time. But while it is a disaster for uninformed investors, it is also a potential opportunity for unemotional investors who have done the hard work and can take advantage of indiscriminate selling.
A few of the important lessons that emanate from all of this. Common Sense – good investing requires common sense. Buying something that’s expensive in the hope someone will pay more for it, is speculating, it’s not investing. Rear-View Mirror – Investors have a tendency to chase performance. That is buying something because it’s gone up a lot, and they’re wanting to chase performance. Understand – if you don’t understand something, don’t invest. Expect the Unexpected – Don’t set your portfolio up for that perfect outcome. Winning in the investment game is not losing. Don’t be disappointed in lagging a bull market, it’s often the price to pay for admission to long-term market-beating results. It’s the outperformance in down markets which drive long term gains. You can’t run a portfolio optimized for a bull market that will perform well in a down market. If you remain unemotional, focus on the intrinsic worth of your companies rather than market gyrations, the renewed increase in volatility is an opportunity, not a threat.
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