This is a two part series on uncertainty and luck in the stock market. Read part two here.
It goes without saying that investing comes with a certain degree of uncertainty. No one can predict where the market is going. Even with the safest government bonds, there is a chance that they will default (an extremely low chance, but still there). This means that a certain degree of luck comes into play when investing, since this is an area out of our control.
Investing has an additional dimension which increases uncertainty as compared to other things like lotteries. This aspect is time. The question of time comes into play in the most fundamental idea of earning money in the stock market: buying low and selling high. When is the right time to buy and sell?
In the context of FIRE through ETFs, most of the uncertainty is removed if you dollar cost average. Since you are buying most of the market, you do not need to be concerned about which company is going to turn out better. However, uncertainty comes into play through sequence of returns risk a few years before and after the retirement mark. There has been discussions about using equity glide paths and bond ladders to mitigate that risk.
Uncertainty makes investing in individual stocks much more complicated than ETFs. Even if we used fundamental analysis to find a ‘good’ company with a decent margin of safety, its price might not go up for many years. We cannot be certain about the reason for this, as it could be because of uncertainty, or that our FA missed something bad somewhere. In order to be successful, we need to have conviction in ourselves (this will be elaborated on later).
I had an experience that reinforced my belief that luck plays a part in investing. Earlier in my investing days, one of the stocks in my portfolio shot up a few days after I bought it (causing the jump in the graph here). Why that particular stock over any others? I believe it is just luck or chance. I had no way of knowing beforehand.
Areas of Control
We have to recognise that there are certain things we can control, and others we cannot. We should focus on managing things within our control.
Since we cannot control the stock market fluctuations, we have to look at other areas. These areas are usually in our minds (psychological) or our personal financial plans.
The first area we can look at is how we analyse stocks. No matter what type of analysis we use, we have to be sure that it is as robust as possible. Are there checks to make sure the company continues to do well (if using FA)? Are the assumptions of your strategy correct (if using TA)? By looking at our analysis method(s), we can minimise the ‘false positives’ and focus on the actual stocks instead.
The second is having conviction. This is linked to the previous point of having a robust analysis. Conviction means believing in your analysis and the stock, even when the price falls (assuming the change is not linked to your analysis, i.e. not the CEO running away with the company’s money, etc).
For example, one of my stocks has fallen 10% from my entry price. When it fell, I did not even think of selling it, but considered buying more. In the end, I did not buy as I feel the price is not that attractive. Perhaps if it falls another 10%, I might consider buying to average down.
Having conviction is important if we want multi-baggers. Take bitcoin for example. I used to think that I would have been a millionaire if I just bought bitcoin (100 bitcoins at $1 would be worth $1,000,000 when bitcoin hit $10,000). However, after thinking about it, I concluded that I would not have become a millionaire even if I bought bitcoin at $1. Why? Because I did not have conviction. I did not buy bitcoin in the first place because I did not believe that bitcoin would become a currency.
Imagine if I had bought bitcoin at $1. When it rose to $2, would I have sold it? Maybe. $10? Even more likely. $50? $100? $500? $1,000? The truth is, I did not believe in bitcoin and would likely have sold it long before it hit $10,000. This is why I am not a bitcoin millionaire.
However, we should note that having conviction can also be dangerous. Believing in the wrong stock can cause you very large losses. This is why having a robust analysis is extremely important. Even bitcoin fell 60-70% from its high.
We should have a plan when SHTF (hey that rhymes). Since we know the market fluctuates, we should expect the market to eventually crash. We should be prepared for when it comes.
First and foremost, I have an emergency fund. This ensures that I have a cushion in case of a financial emergency, like a loss of income or unexpected expense. During a recession, it may be difficult to get credit. Secured lending facilities may also be affected, for example a HELOC might be affected by falling home prices. However, loans against a life insurance plan or fixed deposits might not be affected.
Secondly, I have a warchest (extra money to be deployed into the market). This allows me to take up enticing offers by Mr Market whenever he is depressed.
Having a backup plan allows me to protect myself and take action (within my control) during market crashes (out of my control).
Uncertainty makes investing not a simple task, and unfortunately, there is no single answer that solves everything. However, if we focus on the things we can control, it is possible to tweak the chances ever so slightly in our favour.