In booming bull markets, most market participants ignore their downside risk as they get wrapped up in the excitement. At market tops, it is common that market participants put much more weight on the upside potential.
Whenever an investment is considered, it is very important that a potential buyer consider the downside, as well as, the upside potential. Doing this as equally as possible is important. As humans, our minds have a tendency to focus on the positives in up markets and on the negatives in down markets. Like dating, everyone is multi-faceted. You have to consider the good characteristics and the bad characteristics. There is no free lunch; your date comes as a “full package”.
This is where the recency bias kicks in at full strength. Recency bias occurs when people more prominently recall and emphasize recent events and observations than those in the near or distant past. This causes many market participants to buy high and sell low.
Points to keep in mind:
- Always keep a margin of safety. This means to buy securities when they are relatively cheap and refrain from buying when they are relatively high. Think of it this way. It is not as risky to free climb (no ropes) a rock face when you are 5 feet from the ground, but it is a whole different story when you are 300 feet up.
- When buying and selling securities, look at both sides of the coin. EVERY security always has good and bad attributes. There is no free lunch!
- Think independently. Stay away from “crowd think”. The crowd can be right, but it will also lead you in the wrong direction a lot of times. If you are in a crowd, you may feel safe, but if there is a bomb in the crowd, you all die!
- Evaluate securities separately from the market. Look at the fundamentals of the security that are not determined by the market. The market price is just the collective evaluation (crowd opinion) of the value of the security. The market price can often be wrong.
- Don’t let emotions get the best of you. People who are calm during challenging times are often in a much more effective position.
The winds are picking up. It is a good time to keep cool!
