What's my strategy in today's market?

Mar 6, 2007 by Adam C. Powell, Ph.D.

The market is falling, but I have chosen to ride it down. Some of you may think that I am like one of the violinists on the Titanic, who kept on playing as the ship sank into the sea. In this entry, I’d like to attempt to assure you that my behavior is rational. At the moment, I am currently holding

• DVY (Dogs of the Dow – high dividend U.S. stocks)
• EPP (Asia without Japan)
• EWM (Malaysia)
• EWT (Taiwan)
• EWY (Korea)
• EWZ (Brazil)
• FEZ (Europe)
• FXI (China)
• ICF (U.S. real estate)
• INP (India)
• IYT (U.S. transportation)

Why am I waiting the market out? I believe that the equities I am holding will exceed expectations in the long-term. If growth does not happen in the U.S., East Asia, India, Europe, or Latin America, I will have more troubles to worry about than the stock market.
 In the long run, the stock market outperforms the bond market. Unfortunately, the stock market has far more variance in the short run than in the long run. As people are risk-averse, they tend to sell their stocks as they are going down, or simply not buy them in the first place. As a result, they end up not holding stocks as the prices of the depressed stocks rise, and lose out on the opportunity to make the gains.
In some of my earlier entries about Prospect Theory, I mentioned that people feel losses about 2.2x more than they feel gains. Thus, the sadness of losing $1.00 is equal to the happiness of making $2.20. Given that a loss is “worse” than a gain, people have the tendency to sell things quickly when there are losses than when there are gains.
Rapid sales in the event of a downturn may be exacerbated by limit trading. People often set their brokerage accounts to automatically sell off shares if they dip below a specified price. Institutional investors may be required to have similar behavior. Thus, when a stock’s price dips a bit, it sets off a cascade of trades which increase the supply of shares, further depressing the price. As a result, a stock can quickly trade for far less than it was originally worth due to only a small decline in investor expectations for it.
Given my awareness of the risk-aversion of investors, the long term performance of the stok market, and the effect of automatic trading on prices, I feel that it is wise for me to hold my course. I think that my investments are in fundamentally solid assets, and that I have time to wait for them to correct. I do not need to liquefy my portfolio for at least five years, and thus can afford to invest on a long horizon. I have yet to make my IRA contribution for the year, and plan to make it some time this month.