Saturday, March 28, 2009

Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out

Historical market data explains why many investors, including myself, missed on the recent surge in stock prices

Since my last post the markets have astonishingly recovered over 20%. A couple of press releases by Citi and Bank of America were enough to send the financial sector sky rocketing with these two banking giants doubling their stock prices.

After witnessing such extreme movements up in stock prices I often try to review my thought and decision making process, or to put it in simpler terms, try to figure out why on earth I wasn't a part of the party?

Two weeks ago it seemed like the biggest retail banks in the US may well be on their way to nationalization. The state of the economy seemed poorer than ever and no hope was in sight. The S&P500 stood at 676 and there were no indications something is about to change.
Still, it is the nature of the markets to be cyclical and what goes down usually comes up. Even in these difficult days we've seen the markets go up by as much as 10% a day only to come crushing down again.

It can be quite frustrating to have your predictions and instincts be proved right on the market while you didn't actually have enough confidence to carry them out. Still, short term trading, whether it is performed on an hourly, daily, monthly or even longer time periods is very risky.
Catching the market at its very low is an impossible mission. No one is able to constantly identify the turning point in the markets while strangely enough many think they can. The legendary Warren Buffet had recently reinvested significantly into the market saying he is almost certain we've got a way to go before the markets turn but he is experienced enough to know that he can't time the market.

A look at the data

As readers of The Personal Financier are surely aware by know psychology plays many tricks on investors.

The human mind is not very good in handling large amounts of data over a historical period. We cannot conclude with success from market data we've heard or read through over a period of time.

Just imagine how many times you've heard of price shifts of a certain stock over a week's period, for example. Most of the time you'll be more than certain that stock's price has risen considerably while it actually didn't gain as much as you'd expect. The reason is we more attuned to positive news on stock than negative and we naturally remember and cling to up movements in prices rather than down movements.

The same phenomenon exists in long term trading. Raw data proves there are only a handful of days in which stocks actually gain or lose significantly. These, therefore, cannot be timed and identified in advance.

There were approximately 4,559 trading days between January 1st 1990 and February 2nd 2008. Only 51 of these days yielded a price change of over 5% in the Nasdaq, and a mere 8 days in the S&P. Maybe 5% is too much to ask for? If we suffice with 3% the numbers change to 238 days for the Nasdaq's and 59 days for the S&P.

What are our chances of catching such days? Very basic statistics quickly determines we have a 1.1% chance of catching a 5% price shift and 5.2% chance of catching a 3% price shift in the Nasdaq. The S&P's statistics are even "worse" 0.2% chance of a 5% price shift and 1.3% chance of a 3% price shift.

The long tail or 80/20 principle work here as well. The numbers are a little different but the principle remains. The majority of days will end in price shifts of fewer than 1% or 1%-3%. That is the long tail of trading days or the "80%".

Smart investing

In order to really capitalize on short term market gains, as the one we had only recently witnessed one must be constantly present in the market. Adjusting portfolio exposure to stock and other financial instruments slowly and gradually is the right way to work.
Sure, you'll experience the short term losses as well but the working assumption is that on average the gain is higher than the loss.

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