Fear Can Be Logical

I've heard so many people say that the market is a rational place to put your money, only to be confounded later when there is some unbelievable run on stocks in either the positive or negative direction. They seem to be left wondering how such a thing could happen. I think I can clear this up a little. It's just perception.

On an individual level, it's perfectly rational to place your extra money in the markets in the hope that it will increase in value. That's rational. It's also rational to withdraw your money the moment you see it reduced in value. You don't want to lose your cash. You're trying to get more. So on a micro level, you're doing exactly what is correct for you, although most technical analysts will say that pulling your money away due to your fear is an emotion, and emotions aren't rational. Which isn't always true. What could be more rational than walking away from a scenario in which you genuinely believe you could lose part of your livelihood?

But on a macro level that kind of activity looks really bad. On good news of mediocre companies doing something well, a stock can climb to many times its legitimate worth. We then say it's “overvalued.” But I have to ask... Overvalued according to whom? The disinterested person doing the valuing, or the individual making a fortune? The reverse is also true for “undervalued” stocks. Here is our subjectivism.

On a macro level, these wild swings appear to have no reality-based explanation. From a distance it looks as though there are millions of people running into and out of stocks in haphazard fashion, like a group of mindless lemmings, one following the other for no particular reason. We think they are thinking: “He's going that way, so I'll go that way.” But it just isn't that simple.

On the other hand, what successful investors and analysts tell us to do is put aside our emotions, let our portfolios weather the storms, and ignore the reversals, flat spots and runs in favor of a more nebulous, and as yet, unrealized, unforeseeable long term goal. Now here is where we become irrational. This is essentially hope. Watching total strangers take money out of our pockets, and doing nothing to prevent it goes against all rationality. The most logical thing an individual can do is take immediate action to stem such activities. But we're told not to do that. We're told to let it ride, and that this is the most logical thing we can do. It may, in fact, be the method of operation of the more successful investors. But they are remaining illogical in the face of an extraordinary amount of information to the contrary. If we could know factually where the tops and bottoms were going to be, we could simply make decisions about when to enter and exit. We could eliminate guessing and hope. Now that would be logical.

What I'm trying to say is that what most people believe about the market is that individuals trading there are doing so irrationally, while the market itself works in a totally rational fashion. But that's not exactly correct. The market as a whole only appears to be irrational, because of our perceptions about “heard” responses to good or bad news. And that is also subjective.

At some point in the future, I would like to see the field of technical analysis incorporate the price of fear into a formula. For now it's only wishful thinking. But maybe with such a formula, we can one day put a premium on fear, and reduce it to little more than a blip on our screens.

But for now, I have here a jpeg of my trading screen. You can see the overall effect of bad news. The news that the company might have to go through an "organized" bankruptcy. GM went down significantly. First the quickest, most savvy investors sold (1). Then a few deal seekers moved in (2). Then the rest of the buying public sold (3). I get to see this sort of thing all the time. I actually made a little on this stock. I had enough logical fear to get out before the big dip.

Here is an interesting blog, showing that GM is now worth less than Gamestop.