Avoid the Herd Instinct

Linda Goin

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Greed and herd instinct are powerful, until overtaken by fear. But fear (survival) is a two and a half to three times more powerful emotion than greed. That’s why bear markets take place three times faster than bull markets. But, for now, the trail of money is into stocks. And money is to the market what blood is to the human body.

—R. E. McMaster

In spite of the severe blow to our country and the NYC financial district on September 11, the stock market survives. In spite of downturns in the advertising, transportation, and steel industries, the market survives. In spite of war, presidential voting fiascos, and dot.com failures, the market survives.

However, market volatility is part and parcel of equity investments. There’s no promise, no guarantee, no one to catch you if you fall into the trap called non-diversity. But you already know the importance of portfolio diversification. The real question is whether you have the nerve to hold onto your well-researched stock choices when they plummet 50%.

Market volatility was earmarked in the 1960s when Eugene Fama, who is the current finance professor at the University of Chicago, generated the Efficient Market Hypothesis (EMH) in a Ph.D. dissertation. This hotly debated theory states that, given the presence of intelligent, well-informed investors, it’s very unlikely prices in securities markets will vary significantly from their true value.

There are three forms of the EMH:

The Weak form states all past market prices and data are fully reflected in securities prices. This is the emotional state, when technical analysis is useless.

The Strong form states all information is fully reflected in securities prices. In this state, even insider information is useless.

In this extremely simplistic form, the EMH makes some sense. However, if every investor believed the market was this efficient, then the market wouldn’t be efficient because no one would analyze the market. If you think we don’t need market analysts, then you need to hand your money to your kids and let them loose at the local toy store. YOU are an analyst when you decipher the market for your own portfolio.

Hopefully, you don’t buy into the when skirts rise, so does the stock market mentality, because your money is too precious to be that frivolous. However, you don’t have to be a rocket scientist to make the EMH and other theories on market volatility work for you. In fact, we can make up a few theories about volatility right here and now. For example:

The Fianc Theory: Consider quarterly earnings reports. Four times per year we watch our stocks go through gyrations most of us couldn’t duplicate on a dance floor. If your company reports a good quarter, you can watch your stock head north approximately four hours before the report is issued until perhaps a week after the report. When the dust settles, your stock does, also. You might see a few pennies on the upside, but nothing like what you saw when the news was first announced.

If your company reports a lousy quarter, you can watch the same action, only in reverse. Both cases are similar to a bachelor party. You don’t want to know about the girl in the cake, how much the primary suspect drank, or whether your joint checking account will be attached for the room your fianc and his buddies demolished. All you need to know is that your fianc survived and will make it to the altar. Similarly, you want to know your company survived, and will make it through the next quarter. As a buy-and-holder the best thing to do is look the other way, especially if you’ve done your homework. Hopefully, you won’t have any negative surprises.

The TGIF Theory: No matter how your stock has fared through the week, most times it will sit and sag on Friday after 1pm. This is a great time to see where you stand if you want to buy or sell your stock (more about selling next week). So, while you sit and sag on a Friday afternoon, take a moment to glance at your portfolio to see how your stock managed the workweek.

This is NOT a go-ahead to buy or sell on any given Friday, as you’ll play to a rather vague crowd. Just like you, most folks want to head home early for the weekend so the volume will probably be lower then the rest of the week. Unless, of course, you want to apply the next theory to a Friday.

Uncle Sam Theory: Watch for this action in early April, when stocks might sag in response to yearly tax payments. Many folks use their portfolio monies to make these payments. This theory also applies to large shareholders who decide they’d rather have a vacation in Aruba than hold onto their shares, or to any large business that needs to sell their shares to make payments for any reason. The rebound is usually fairly quick.

The last theory is the Hurricane Theory. If you’ve ever lived in hurricane country, you know about the warnings. You might decide to move out of the territory, or you might board up and weather the storm. It’s your choice, and you can’t say you weren’t warned. You’ll hear rumors, gossip, and reports on the news. Some of it may be true, and some of it might be just plain old muck. The only guarantee is that the wind will blow in one direction, and then it will blow the other way. If you have a stock that is subject to this theory, make sure you have the guts to bear up under constant winds and threat of destruction.

You can fabricate your own theories for market volatility. After you spend a few hours playing this game with your children, you’ll realize how important it is to keep your head when everyone else runs with the lemmings. When you’re in for the long haul, a few sagging TGIFs don’t really matter.