Possibly the greatest industrialist of America’s history, John D. Rockefeller once said that “The way to make money is to buy when blood is running in the streets.” Those words of wisdom have seldom been more pertinent. As the market correction continues, fear is in the air and blood is running on the streets. Maintaining a rational decision making framework during a correction is essential. Here is what you need to do to come out of this correction in the black.
Have A Clear decision Making Framework
Anyone can make money during a boom, when it seems like everything an investor touches turns to gold. As another great American investor, Warren Buffett, said, “Only when the tide goes out do you discover who’s been swimming naked”.
The greatest investors have clear decision making frameworks that allow them to make clear decisions precisely at those moments where emotions are likely to cloud judgement. The best decision-making framework is a probabilistic one.
Use decision trees to help you map out a path to profitability based on the information you have. Decision trees may be a cold way to decide, but they divorce you from the emotion of the moment and provide you with a mechanism to weigh the various scenarios you face. Let’s call this your macro decision making model.
In addition, when making micro decisions, such as whether to buy this stock, or enter that sector, and such, you need a framework that tells you what decision making tools are appropriate for what specific situation. For instance, a discounted cash flow analysis is not always appropriate, especially in highly volatile scenarios. You need a decision profile that gives you the flexibility to use the range of tools available to you, at the appropriate times. In short, this will help you decide how to decide.
Look Beyond the Now
As investors, we have to assume some kind of market efficiency. In other words, we have to assume that in most instances, the market is right. That’s the wisdom of crowds. Your first question to ask yourself is, “Is the market right”, and you do this by looking toward the long-term. The only edge today’s investor has, is time. In the short run, the market is prone to manic-depressive moments, but in the long run, the market tends to be right. If the market is overreacting to events now, that presents you with an opportunity to invest cheaply during this correction, trusting that stocks will appreciate over time and your bet will pay off.
Figuring out if the market is wrong is all about the long-term. For instance, investors scared away from airlines and oil stocks during the first months of the pandemic, missed out on huge gains. The trough of the airline stocks was in May 25 2020, and a year later, United Airlines had returned 200% for investors, and American Airlines had made 190% for investors. At the trough, United was down more than 70% and American Airlines was doan over 60%.
Figure Out How Much you have Lost
Now, most people will tell you to stay in the markets. That’s not necessarily true. The flip side to the story of airlines and energy is this: the investors who benefited the most from the surge in prices since, are those who got in at the bottom. However, those investors who held stock prior to the crash, did not make up their losses even a year later, and some are still in the black today. Here’s some basic math to explain why: if a stock declines 70%, you need the price to go up 333% for you to JUST break even. At some point, as you pacing over your Full Coverage Painting & Flooring, you have to make a tough decision and that may be that you have to cut your losses if the performance you need to get back on track is too high. The investors who exit declining markets aren’t always fearful or stupîd. Sometimes, the numbers stop making sense. If you require heroic performances to get back in the black, then you need to cut your losses.
Contrarianism only works when it makes sense. Sometimes, the crowd is right.
Rebalance Your Portfolio
Many investors rebalance their portfolios in self-injurious ways, cutting their winners and letting their losers run, when you should be rebalancing the other way. You want to tilt your portfolio toward your winners. This will happen naturally if you leave your portfolio alone, but there are active ways to prune the hedges, for one, as I said above, figuring out what positions you need to get rid of. You do this by rebalancing your portfolio around geometric returns, and not your average returns. Do this not just for individual stocks but across asset classes. This will give your portfolio greater protection and allow for superior performance.