Investment is premised on prediction. This is true whether you are a market timer, a stock picker or an indexer.
What should you do if the predictions that underlie your investments prove wrong?
What You Should Do When Your Thesis Is Proven Wrong
An investment thesis can turn out to be wrong in any number of ways. For example, the causal macro or micro scenarios that were posited to impact prices may not materialize as predicted, when predicted. Even if the predicted scenarios do materialize, the investment thesis might still turn out to be wrong if market prices to not respond in the manner anticipated, when anticipated.
There are two main things an investor should do when their investment thesis has been proven to be wrong in one or more critical respects:
1. Liquidate immediately any risk positions (long or short) that were based upon the incorrect investment thesis.
2. Invest the proceeds in low-risk and highly liquid and interest-bearing near-cash instruments such as savings accounts, money market funds or high quality short-term bonds/bond funds.
What You Should Not Do When Your Investment Thesis Is Proven Wrong
As important as knowing what you should do is to anticipate the things that you will be strongly tempted to do and which you should not do.
1. Succumb to the temptation to do exactly the opposite of which you have being doing (e.g. go from short to long) and join the recent trend in order to avoid missing out on further gains.
2. Succumb to the temptation to "dig in" or "double down" in order to recoup losses.
Both A and B are very natural responses and are often experienced as powerful urges. However, these urges must be actively countered, as they are both irrational and counterproductive. Note that both reactions are essentially "reactive" in nature.
- The reaction in #1 typically stems from the following sources: (NYSE:I) A desire to "ameliorate" past losses; (ii) and/or urge to "join the safety of the herd."
- The reaction in #2 typically stems from the following sources: A desire to "recoup" perceived losses in a hoped-for reversal of the current trend; (ii) and/or a rebellious urge to "fight back" and defy conventional opinion.
In psychological terms, the former can be roughly thought of as a kind of "flight" response while the latter can be thought of as a kind of "fight" response. It is important to be aware that the urges to "make-up" past losses, to "join the herd" or to "defy the crowd" are not only impediments to clear thought and action - they constitute classic psychological traps.
How do you avoid the strong temptations to do what you should not do?
The best way to avoid the "should nots" is to immediately execute the two "shoulds" as outlined earlier. Formally severing the connection between the investment and the investor really does go a long way towards altering the nature of the ideological and emotional commitment from a psychological standpoint. The formal separation created by the "should" goes a long way towards taking the edge off of the tempting "should nots."
What If You Are In Cash Already?
To summarize thus far: After an investment thesis has been proven wrong, it is my view that an investor should liquidate all risk positions taken on that basis, and then take a "time out" to detach and reset. This is true whether the investment has been in an index product such as (NYSEARCA:SPY), (NYSEARCA:DIA), (NASDAQ:QQQ) or individual securities such as (NASDAQ:AAPL), (NASDAQ:MSFT) or (NYSE:T).
But what if you are neither long nor short risk assets, and your investment thesis recently proven wrong is precisely what led you to be invested in cash and/or short-term bonds (including money market funds) in the first place?
Do this: Analyze the position carefully and rebalance this portfolio allocation to maximize the yield relative to risk exposure. This purpose of this exercise is to "refresh" the position within the allocation as well as to "refresh" your psychological state. However, from a structural point of view, you should not change the asset allocation at all.
The Cash Default Position
It is my philosophical view that money market instruments and short-term bond funds (i.e. lowest order risk assets) should almost always constitute the default position for investors. In particular, it is my view that all investors should revert to cash/short-term bonds (including money market funds) when things have gone wrong and/or when conviction/clarity is absent.
The cash default position is founded on two ideas: The first is a matter of logic: Incremental risk should only be assumed as a function of incremental conviction (obtained by obtaining incremental information and/or perspective) regarding expected return. Therefore, an absence conviction, risk should be kept to a bare minimum. The second reason is pragmatic: Investment analysis and decisions are best made from an intellectual and emotional state that is as detached as possible from ideological and financial fetters. Therefore, development of a new investment thesis is best undertaken while capital in its safest and most liquid forms.
Note this aspect in which my investment philosophy is completely at odds with the conventional (and in my view insane) ideology that the investment industry has drilled into mass culture which is that the default position of investors should be to be "fully invested" to risk assets at all times - and to equities in particular - even if they have no particular considered view of macro/micro conditions.
Beginning on October 27, 2011, based on a series of causes that I have clearly laid out in my writings, I predicted that the S&P 500 would top out before April 27, 2012 and that the index would subsequently commence a decline to the area between 950 and 1,020. As events turned out, the S&P 500 index seemed to top out on April 2, 2012 and subsequently corrected by 10.1% from the high of 1,422 to a low of 1,278. However, since the afore-mentioned correction, the S&P has recovered to a high of 1,419 on August 17.
Many of the causal elements of my original investment thesis have proven to be correct. However, if the market closes above 1422 and sustains this level, my thesis in regard to price and time evolution will be proven wrong. If this indeed occurs, as it now appears likely, I will publish a future article with an ex-post analysis of the entire investment thesis.
What will I do investment-wise if and when my thesis proves to be wrong? Pursuant to my investment philosophy, readers can be assured that I will NOT do either of two things: A) Automatically reverse my position and join the crowd, or B) dig in or double down.
What will I do? A) I will recalibrate short-term bond and money market positions. B) I will create some distance with the ill-fated euro-centered thesis by focusing on other issues and, when necessary, looking at the same issue from different new perspectives.
A final word: How do you deal psychologically with the disappointment of having been in cash? This is my advice:
1. A distinction must be made between good investment decisions based on a sound calculation of expected return and situations in which expected return calculations went awry. For example, based on expected return criteria, abstaining from playing the lottery, slot machines or craps is always a good decision that needn't ever be regretted -- no matter how much money other people have won playing those games. Another example: Based on expected return criteria, it is a good decision to bet against 10 coin tosses resulting in heads on 9 occasions. One should not regret making that bet even if one loses it.
2. Now assume that, after the fact, you are able to discern that your expected return calculation was incorrect based on information that was available to you at the time of your investment. How do you approach this? First, recognize and error and make note of the causes so as to avoid repetition. Second, be grateful. Yes, grateful! Blessed is the investor that has been wrong and that loses little or nothing. If an investor could limit their losses to near zero when their investment theses are wrong, their chances of success over the long term are very good indeed!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.