What should investors do now?

"What should investors do now?"

With the markets having melted down, the popular media, especially television media poses such questions to 'market experts'. The underlying thought is what investors should do at the current juncture to make money (or not lose it).

But let me ask you a different question:
"Why do you think you will at all make money in the market? What makes you think you are capable of making money from the markets?"

We walk into the trading arena hoping to make money. We see others making money or hear about others making money in the stock markets and enter to get our share in the loot.

There is a large class of people (mainly in the acedemic world) that thinks that markets are very efficient. They believe in what is commonly called the Efficient Market Hypothesis (EMH). According to this, the markets are very efficient and prices reflect all known information. i.e. they are never overpriced nor underpriced, just perfectly priced. New information gets assimilated in the price almost instantaneously. Markets behave rationally. Everyone knows all the information available and hence no single investor can get more than market returns over time.

We all know that the EMH fails miserably in the real world. There are people who make a lot of money consistantly, there are people who fail all the time. Markets do not behave rationally and there are booms, manias, crashes and busts that take place over and over again.

That markets behave irrationally is to be expected since markets are a social process. People behave irrationally. This leads to pricing mistakes. Pricing mistakes create prospects of above-average profits. All active investing is in reality an attempt to take advantage of such errors. We try to exploit others' errors as others try to exploit ours. Superior returns come from successfully exploiting such errors.

But markets are a zero sum game. One man's gain is another man's loss. So why should we think that we can gain at someone else's expense? What skills do we possess that would give us the ability to profit at others' mistakes? Why would others give us their hard earned money?

The answer partially lies in our investing philosophy (and every investor should have one). What is an investing philosophy? An investing philosophy is a coherant way of thinking about how markets work, how they don't work, and what mistakes they make. It is our view of how the market functions, and when it is right and when it is wrong. Viewed through the lense of our investing philosophy, we percieve certain market outcomes as correct and certain others as errors. It is then these errors that we attempt to exploit.

Behind every investing pilosophy is the assumption that markets make pricing errors. An example of one investing philosophy could be that markets tend to overvalue growth and underestimate the value of existing assets. This could lead to different investing strategies designed to exploit such conditions, whenever they exist. Or you could have a philosophy that works on the irrational human tendency to join herds, which could lead to various momentum and trend following strategies. Perhaps you think that people get very pessimistic at times and stocks get very cheap which give great buying opportunities...that is also a valid thought.

Most people roam around the marketplace without any definitive investing philosophy. Trading the markets without one is like driving a boat without a rudder. You simply cannot move in the direction of your choice. Anchoring decisions to an investing philosophy is critical for longer term success.

Having understood this, we must note that markets do not make the same mistake every day or every week or every month or even every year. In some years, the mood might be so pessimistic that stocks get seriously undervalued. In other years, herd mentality might dominate so much that stocks take off in parabolic fashion. While in other times, markets might simply move up and down without going anywhere. Hence no investing philosophy would make money all the time.

Every investor needs to follow his/her investing philosophy/philosophies regardless of market conditions. If you believe in value investing, you should search for stocks that are cheap. If you believe in trend trading, you should search for stocks that are trending higher or lower. If you believe in arbitrage, you should seek arbitrage opportunities. There is no single correct answer.

"What should investors do now?" Such questions reflect a basic lack of understanding of the investing process. Investors need to reflect and develop a workable investing philosophy suited to themselves and their objectives, develop sound investing strategies around it and stick with them regardless of external conditions.