A Little Soul Searching After a Rough Patch in the Market

Jared Dillian |

It’s been a tough couple of weeks.

I keep a mostly hedged book, long and short, so it’s rare that I get my head caved in on every position at the same time. But that’s pretty much what has happened. My shorts haven’t worked because they’re either rate-sensitive or Canadian banks. Meanwhile the longs, which include a lot of emerging markets—well, you know what has happened with those.

Nothing has changed with the long-term thesis. Nothing. But the mark-to-market is no fun, and any time you’re facing negative P&L, you have to do some soul searching and think about whether you still like these trades or they are permanently broken.

Anyway, you can read more about this discussion either in Bull’s Eye Investor or my newsletter for sophisticated investors, The Daily Dirtnap.

Fight or Flight?

What I really want to focus on today is the psychology of losing. I don’t care who you are, or how smart or confident you sound on Twitter, everyone in this business gets to feel pain at one time or another. You do your best to minimize it and mitigate it, but everyone will get hammered eventually. It happens to the best of us.

So what do you do about it?

This is where I get all Dicky Fox on you and start dispensing the motivational quotes. Like, it is human nature not to log on and look at the losses. Or the 1995 equivalent, throwing away the brokerage statement. People hide. They go into shutdown mode.

That is the worst thing you can do.

Hopefully the losses will motivate you to take some action. Most of the time, that means cutting the losses, but in rare, high-conviction cases, you may decide you want more risk. But sitting still and getting bludgeoned is not going to help. I assure you, it will get worse before it gets better. If it ever gets better. That is the nature of trends. And you are on the wrong side of one.

This is the reality of it: The financial markets are like a fight. You have to get up, ready to fight, every day. You don’t get to take a break from the fight, unless you just sell everything and take your ball and go home. Which is okay. You can run away, live to fight another day. Running is often preferable to fighting. I run all the time.

This time, I’m going to fight.

Endowment Effect

Here is thing number two. Have you ever heard of something called “endowment effect?” That’s the phenomenon where people get emotionally attached to things. Like the coffee mug you got in college. You wouldn’t sell it for $50, even though it’s only worth $5.

People get emotionally attached to stocks too. Which is weird because nobody has certificates anymore; it’s just a ticker in a web browser. But people are very protective of their ideas. It’s their idea, and nobody wants to admit that they are wrong and abandon this idea that could one day make them lots of money.

So you have two options. You can admit you’re wrong and sell it and go do something else, or you can try to wait out the market.

It can be very hard to wait out the market.

Inevitably, what happens to people who wait out the market is that they wait and wait and wait until they get to the point of maximum pain, and then puke the stock—on the lows.

That’s Wall Street.

If you have a number in your mind of how low something can go, your estimate is probably off. Like, if you’re long XYZ at $20, and it’s down from $25, and you think you can hang on until $15, it’s probably going to $5. People lack imagination about how bad the losses can get. They literally cannot conceive of things going horribly wrong. After doing this for 16 years, and seeing things go horribly wrong a bunch of times, I know.

All of my positions could easily get cut in half from here. Easily.

And then people start talking about the concept of “intrinsic value.” Like, this stock has $10 in cash on the balance sheet, there is no way that it can go to $10. And then it goes to $5. Seen it happen. Many times.

That goes for commodities, too. There is no reason why we can’t have $2 corn, or $20 oil, or $200 gold. All of these scenarios are unlikely, but there is no rule that corn or oil or gold can’t drop below a certain price.

If there is such a thing as fair value, the stock will go below it, for sure.

Loser

But more broadly, when people start getting hit, they get demoralized, which is bad because that’s the worst time to get demoralized. When the market is volatile, there are more opportunities (especially in options, where implied volatility is high).

I’ve written a lot of very stern comments here about not having discipline, but I should point out that the horrible bear markets of 2001 and 2008 gave rise to an entire generation of permabears. But the 2000s are not a good sample. For most of the history of the stock market, people are rewarded when they add to long positions on corrections of 10-20%.

You can find lots of reasons to buy stocks (valuation, strong USD, emerging markets, whatever), but there are always reasons not to buy stocks. There were reasons not to buy stocks in March of 2009. You can talk yourself out of a lot of opportunities if you only listen to the negative.

I don’t have perfect knowledge of how this is going to turn out. I don’t. But it doesn’t seem like a generational bear market to me. More likely than not, a year from now stocks will be higher. That’s as good of a prediction as I can offer.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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