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Market Timing and Human Emotions

Updated: Sep 9

3/9/2022


When you invest it’s almost as if the market knows exactly what you are afraid of and what would be really gratifying to you and shakes you in between the two until you are exhausted, numb, or both.

When you own an investment, you can feel imbedded, like a soldier or a teammate, and in turn feel comradery and grateful when you have good returns or resentful when they are negative. It feels alive because it delivers elation and sadness the way a real relationship can.

We lovingly call positions horses and rocket ships and have patience when they have a misstep. We envy those positions that outperform; and then own them with gratitude when they dip to within our grasp. Each position can feel like a friend with a long back story of how and why you two met. Some positions can feel even closer, like family, regardless of what happens, you won’t sell.

Investing taps into many emotions we wish we could turn off. Fear and greed are not helpful to making investment decisions with your own money. Its not helpful that the investing landscape is forever dark from jargon and complexity and littered with exploded landmines named Madoff, Lay, Fuld and Ebbers. Who knows how many unexploded mines lay in wait?

So you’re in the dark, unsure of where to invest next, afraid to move, but also knowing the daunting fear of not moving. Perpetually unsure footing can lead to quick decisions--you never know how long you have before the opportunity leaves. But where can you take a surefooted position in the dark land of mines?

This is the framework we are stuck with. Our emotions are pitted against us. Nothing seems to be a sure thing, and doubt festers under every decision. And then a flare rises from the dark and grabs the attention of everyone. The flare is the latest hot stock. Rising, and gleaming for all to see. It’s got a great back story that erases all doubt, and everyone suddenly seems to be aware of it. Continuing to rise, envy pushes aside reason. You have got to own this; does it matter that you’re paying X today when it will definitely be 10X in the future? And poof! The flare flares out, as flares do. You’ve paid the zenith price of X for what seemed so sure to be a solid investment and are surprised when it is soon trading at 0.4X.

What happened? This is the age-old pattern of flashy returns that attract new investors who pay higher prices for an investment thinking the returns will last only to have returns revert to the mean. This leaves the last buyers (investors who paid the highest prices) as weak holders because they immediately show a loss and will not have confidence in their purchase. They usually sell quickly, and with price momentum turning negative, new cohorts are not attracted to the story anymore. And there is the rub, we usually aren’t aware of great investments until they have great returns, at which point they often are poor places to put money.

There are two classifications of chaos in the world. First Order Chaos doesn’t respond to predictions. Examples of First Order Chaos are the weather, planetary movement, and tides. A First Order Chaos system will not adjust or be influenced by predictions, and they are highly predictable.

A Second Order Chaos does respond to predictions and is influenced by them. Second Order Chaos is inherently unpredictable because so many participants can have an influence on its future. The stock market is the best example of a Second Order Chaos system.

In an unpredictable dark market, with landmines, eye-catching flares, envy, FOMO, greed, and fear how is an investor supposed to win?

The answer is to be aware of all the emotions, but a servant to none. Objectivity and detachment are the guardrails that must be used when investing. Be objective in spotting flares as opportunities that have already passed. Never overpay, never buy an investment that just had a big return. Those are investments ripe to sell, not buy.

Before owning any investment have an exit strategy for both directions. If you buy at a price of X, be honest that you can’t predict where it will go in the future as a second order chaos system, so you need to have a stop loss if you are wrong. The stop price distance from the entry price is subject to the volatility of the investment but also the risk threshold of the investor. 10 – 20% downside might be acceptable to some but seem dangerous to others. If your stop loss is greater than 30% below the entry price, an objective take would be that you paid too much for the investment.

On the upside, a plan should be in place to sell the position if it hits predetermined points. Sale prices should aim to generate returns that are many times greater than the potential downside losses. For example, if you pay X for an investment, you might set a downside sell stop at 0.9X (10% loss); and setup sales at 1.5X (50% return), 2X (100% return), and 3X (200% return).

Be detached from the brightness of flares, and the darkness of the investing landscape by limiting color commentary. The most popular investments are licked up and down by bank analyst. The hot thing is always projected to burn just a little hotter next quarter, and the euphoric price projections analyst put out anchor the investor on what a win will look like. Analysts are almost always late with their commentary, and rarely apologize for being wrong. Do not base a buy or sell decision on an upgrade or downgrade or a new price target. Although a bank analyst might seem to lend credibility to an investment, their guess on where an investment goes is forgotten by the market after about a day.

Ben Graham, a founder of value investing and teacher of Warren Buffett, describes the market’s volatility best with the parable of a person, Mr. Market. Mr. Market is your partner in a private business. Some days Mr. Market wakes up happy and is exuberant and will pay high prices for your share of the business. Some days Mr. Market is nothing but fearful and seems unwilling to buy anything and sets a low offer for your share of the business. Even though the business the two of you share is stable, Mr. Market can act rationally and irrationally. The trick for the investor is to not get caught up in the exuberance or fear, or reasons behind the price movements, but to stay detached. Have very simple thoughts when buying or selling. Is this the price I want to pay for this investment? Is this the price I want to get for selling this investment?

And always wait for your price. You don’t want to be invested in everything, be very selective. This means there will be many misses because Mr. Market doesn’t listen to your whims. That’s OK, just never listen to his.



Justin Hudock

Starboard Wealth Management

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