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E+R=O The Most Important Equation For Investing


The most important equation for investing, and maybe even life is E + R = O. Which stands for Event + Response = Outcome. Meaning that the final Outcome of things that happen each day consists of some Event AND our Response to it. We cannot control Events. Events just happen. We cannot cause the stock market to go up and down. We can't even predict whether it will go up or down. What we can control is our Response to Events, and ultimately, it is our Response that will have the biggest impact on the end result.

For example, many years ago I had a client that was thinking about retiring soon. When markets started to slide in 2007, I recommended that she sell some of her high-gain stocks and get into more of a balanced portfolio, but she decided to keep her portfolio the same. In 2008, markets fell further, dropping some 40%, and she still hung-in there. In early 2009, markets continued to drop! Finally in early March of 2009, she said, "Eric, I can't take it anymore. Let's sell everything and go to something safe." I've seen many people make this decision (response) after various market drops (events), but I will never forget this client, and this day. It was March 9th, 2009, which was literally the absolute bottom of the market. It hasn't dropped a penny lower since that day.

Stocks are up about 200% from that date, but she is not. Stocks dropping is the Event. Her Response was to sell, literally at the worst possible time. The final Outcome is that 8 years later she is still working, still not retired, and her account has never gotten anywhere near to its pre-crash value. The Event (market dropping) was not the biggest factor in the final outcome (value still low), but rather it was her Response (selling low) to that Event that has had the larger, lasting impact. She still blames the Event, when in reality it's her Response to the event that has caused her so much grief.

While we cannot control market Events, we can certainly control how we Respond to market movements. What our research has found is that by analyzing market trends over the last 2 to 3 months, and owning more the markets that are going up and not owning the markets going down in that time-frame, and then repeating that process monthly, may be one of the best ways to Respond to Events. That process generated gains during the 2008 crash. It's why our most conservative momentum model has made money last week while stocks dropped. The problem with continuing to own markets that are in a down trend, is that nobody knows how far it will drop, how long it will take to bottom-out, or how long it will take to recover. The Japanese stock market, for example, is still not above a high it set in 1989! Sometimes, "just hang in there" is not the best advice.

We feel that most of the sell-off from last week is over concerns in China's economy. That is somewhat valid, as it is the 2nd largest economy in the world. BUT, last time I checked, it is China's economy that is bad, not ours, and we don't have anyone invested in China. I'm not going to sit here and tell you though, that the market will quickly reverse. I have no way of predicting what will happen next, and neither does anybody else (not even the good looking people with expensive suits on CNBC).

Events are random. They just happen. Events are out of our control. Responses are not the same as Events. Responses can be void of emotion like fear, void of the desire to predict what will happen next, and void of having only a short-term perspective.

Responses can consist of a rules-based strategy that has worked over decades of good and bad market cycles. Responses can be backed by probabilities of likely outcomes. And Responses can consider the long-term perspective. And that's what we do. That's why we're here to help. What I can tell you is that in one more week we will re-run our monthly analysis and continue the process of owning markets that have the highest probability for continuing up for the next month, and repeat, and repeat, and repeat.

Last week a client in my office asked, "What will happen next in the market?" I moved my crystal ball on my desk in front of him and said, "Take a look, and you tell me." He said, "I don't see anything" and I asked, "Are you sure? Look again." He said, "All I see is my reflection."

"Perfect" I said. "That guy in the reflection, you, is ultimately what's going to determine what really happens next. We won't know which way the market will move, but at least you have the wonderful ability to decide how you will respond. And that's the only thing that matters."

Additional disclosure: The information is purely educational and not intended as an investment recommendation or tax advice.