jankythoughts2

Foreword

I want to start by noting that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, via some formal classes, but mostly self-taught.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

This post is a continuation of Investing vs Speculating, and if you have not read that yet, you probably should before continuing here. There is also a final wrap up to this series, Investing vs Speculation 3. Finally, a separate related post Zero Sum Game rounds up why understanding investing vs speculating is important.

Question

What do you do if the market tanks 50% tomorrow?
The answer, as always, is, “it depends”.

To formulate a proper answer, we first need to discuss why people buy financial assets, because the reason why they buy financial assets is key to understanding their mindset and motives.

Why buy assets

The two main reasons to buy financial assets are: investing and speculating.
I want to note that I have nothing against investing nor speculating.  Both are, in my opinion, critical for the proper functioning of markets.  Therefore, read the following with the understanding that I’m not disparaging either, but just noting their characteristics.

Investing

There are 3 main types of investing: value investing, macro investing and passive investing.

Value investing, where

1. You look deeply at the fundamentals of the company’s business,
2. and try to formulate some sort of projection/model for the path the business will take.
3. Based on your understanding of the risks and characteristics of the business, you then decide what kind of returns you would accept.
4. Based on the returns you would accept, you can then estimate a price which you would be willing to pay.
5. Finally, you buy stock in the company if it is trading for lower than what you’d be willing to pay.  Otherwise, you move on to the next company to evaluate.

For example,
Let’s say I believe StableCo will generate around $100 per year for the next 10 years. StableCo is in a stable industry, so the business is unlikely to grow much, but is also unlikely to decline significantly. Therefore, there’s probably little variance to that $100 earnings that I should expect.

For such a company, I decide that I want at least 7% return per year. That translates to a total market cap of around $1429. That is, I would be willing to buy the whole of StableCo for $1429. If StableCo had 100 shares outstanding, then I would be willing to pay $14.29 per share.

Note: There are various definitions of “value investing”, some of which are really more a form of speculation using quantitative methods. Here, I am referring to the definition of “value investing” as popularized by Benjamin Graham, and that which is espoused by his book “The Intelligent Investor”.

Macro investing, where

1. You are focused more on the macroeconomics side of things.
2. You form models/projections on how different economies and/or sectors of an economy will perform in the near future,
3. and you allocate resources to those which you believe will perform relatively better.

For example,
I analyzed the political, economical and financial policies of two countries, Wakanda and Rohan. Based on my understanding of these policies, and the geographic realities of each country, I’ve decided that:

• Wakanda would be able to commercialize their natural resources. That stream of revenue would allow the government to dramatically improve the lives of its citizens, achieving an annual growth of 10% of its economy.
• Rohan, however, has an economy that’s effectively stuck in the medieval age. Its infrastructure is essentially a series of dirt tracks for horse drawn buggies, and there is little chance its economy will grow by more than 2-3% a year.

Because of these, I decide to allocate my portfolio entirely to Wakanda. Within Wakanda, I further subdivide my portfolio, so that a majority of the portfolio is in industries related to the extraction and export of natural resources.

Passive investing, where

1. You assume, a priori, that the economy generally trends upwards,
2. and so if you buy a bunch of different companies, you’ll be able to diversify away idiosyncratic risk.
3. This then allows you to just make whatever returns the economy provides.

Note that there is significant overlap between passive investing and macro investing. In both, you generally decide on a portfolio allocation at the macro level — domestic economy vs international economies, diversification across sectors, etc.

The main difference, is that in passive investing, you generally don’t form an opinion of how each will perform against the other. Instead, you base your portfolio allocation based on your risk tolerances and other needs.

Answer for investors

As mentioned in Investing vs Speculating, in all cases, your goal is to earn the returns of the businesses that the companies you bought are engaging in.

When you are purely investing, you should buy whenever you feel that the future earnings of the companies you are buying will provide sufficient return for the current prices you are paying today.  As such, the future prices of the companies don’t really matter — what matters is the current prices you are paying now vs the future earnings of the companies.

If you are purely investing, and the stock price of the company you’ve bought tanks by 50%, then you should:

1. Determine if the fundamental characteristics of the business of the company has changed.
2. If not (i.e: your prior model is still accurate), you should either:
   1. Ignore the stock price — after all, you are not looking to earn your return from the stock price, OR
   2. Determine if the new stock price is low enough that you can risk putting more money into the company.
      • Remember that putting more money down in the same asset means increasing your risk to that asset, so you’ll need a larger margin of error to compensate for that risk.
3. If yes (i.e: the fundamentals of the company has changed), you should rebuild your model/projection for the company, then:
   1. Sell the stock if the new projection suggests that at the new stock price, you would not be making the return you are looking for, OR
   2. Ignore the stock price, if in the new model, the new stock price justifies the current investment in that company, OR,
   3. Buy more stock, if in the new model, the new stock price provides enough margin of error to compensate for the additional risk.

Speculating

There are 4 main types of speculation: momentum, mean reversion, event driven and correlation.

For simplicity, I’ll just assume we are buying.  Shorting is just the inverse, and should be fairly easy to reason out.

Momentum is where you expect whatever has gone up in the near past, will continue going up in the near future.

For example,
It has been shown that most stocks show some form of momentum — if a stock has gone up in the recent past, it tends to go up more in the near future.

A simple momentum strategy would be to just buy any stock whose price is above its 50day moving average, and hold them for 1 week. (1)

Mean reversion is where you expect whatever has gone down in the near past, will go up in the near future.

For example,
Over long periods of time, the VIX index tends to revert to a range of around 10-20.

A simple mean reversion strategy here would be to just short the VIX index whenever it is above 80, until it goes below 30. (2)

Event driven is where you expect some event in the near future will cause the asset to go up.

For example,
LargeBuyerCo has announced that it is looking to acquire some companies to expand on its online advertising platform.

You did some research and narrow down the list of candidates to 3 companies which are publicly traded. You buy the stocks of each 3 company, and wait for LargeBuyerCo to announce their targets. (1)

Correlation is where you expect two related time series to exhibit similar performance over time.

For example,
The countries of Gondor and Arnor are close to each other geographically, and share many characteristics such as political climate, monetary and fiscal policies, etc. The citizens of both countries can also move freely between the both countries, and so, each country is the largest trading partner of the other.

Based on these factors, you expect that economies of Gondor and Arnor to be closely linked. You therefore build 2 baskets of stocks — one holding the largest 10 companies in Gondor, and the other building the largest 10 companies of Arnor.

You expect that these 2 baskets of stocks will move very similarly to each other over time, and so whenever one basket is underperforming, you buy that basket and short the other. You do so until the gap between the performance closes, which is when you close your position. (1)

Answer for speculators

As mentioned in Investing vs Speculating, in all cases, your goal is to earn a profit by someone paying more for the asset when you sell it to them.

There are 2 main ways for the value of the asset to go up — either the fundamentals become better (i.e: the asset is fundamentally worth more), or the price multiple becomes higher (i.e: the asset is priced richer).

Note that while we are looking at fundamentals in the first case, we aren’t “investing”!  We are betting that the fundamentals will improve, and we are looking to profit from the increase in the price of the asset when the fundamentals improve, not from the earnings of the businesses because of the same fundamental improvement.

Another name for the second case is the “Greater Fool theory”.  Essentially, you buy an asset without an understanding of whether the fundamentals justify the price, but with the belief that someone else will pay a richer price in the near future.

Examples of where fundamentals may change:

• New product line (e.g: new iPad model)
• Changes in characteristics of the industry (e.g: lithium mining after EVs become popular)
• Inflation (e.g: devaluation of currency)
• Reduced regulations (e.g: more opportunities to squeeze out profits)
• Cyclical industry at trough (e.g: industry wide recent underinvestment due to prior overinvestment)

Examples of where price multiples may change:

• Price insensitive buyer (e.g: buybacks, index inclusion)
• Reduction in risk free rate (i.e: reduced discounting of future earnings)
• General market euphoria/fear (e.g: when a bubble is forming, all stocks tend to do well)

So, what should you do, if the stock of the company you purely speculated in tanks 50%?

1. If you are betting on momentum, then clearly you were wrong, and you should close the position, and maybe even go short instead.
2. If you are betting on mean reversion, then either you were wrong, or you were early.
   Trying to figure out which is generally hard, and requires looking deeper at your model and figuring out what went wrong.
   1. If you believe your model to still be correct, you either hold on the position, or buy more.
   2. If you believe your model was wrong, then you close out the position, and rework your model.
3. If you are betting on an event,
   1. If the drop was after the event, then clearly you were wrong and you should close out the position.
   2. If the event has not occurred, you need to decide if your model of whether the event will still occur, and what that event entails for the stock price is still accurate. 
      1. If so, you should probably hold, and/or buy more.
      2. Otherwise, you should close the position.
4. If you are trying to trade correlations, then the other leg(s) of your trade should have mitigated the bulk of the 50% drawdown.
   1. If not, your model may be wrong, and you should think carefully to see if perhaps you missed something, or if situations have changed, so that the model no longer works.

Wrapping up

Obviously, there is a lot of overlap between all the above.  While for the most part, whether an action is more investing or more speculating is generally obvious, there is also a lot of grey area.

Realistically, very few people purely invest, and very few people purely speculate — it’s mostly a matter of degree.

In some cases, people deceive themselves — they started out trying to speculate, but when the trade went wrong, cognitive dissonance convinces them that they were actually investing, and so they hold on to a bad trade far longer than they should.

In the end, they end up hurting only themselves.

In yet other cases, people start out speculating, but the success of the trade triggers their greed and they convince themselves they had an investment thesis all along.  They too, then, hold on for far too long.

If enough people do this to the same asset, a bubble forms, and for a while (which can be a very long time), everyone can seem to be really smart. Famous bubbles in the past have lasted years… before reality rudely intrudes and everything comes crashing down.

Sometimes flip flopping between investing and speculating is bad, but sometimes it is good.  If you do flip flop, then you should be sure to be very clear to yourself why you are flip flopping.

If you changed a speculative bet into an investment, you should be very clear and very sure about the model you are using, and be sure that the projected returns is at or above your desired return.  You should evaluate everything from scratch, as if it was a new investment.

Otherwise, you stand a fairly good chance of blinding yourself if the stock price deteriorates, by constantly convincing yourself that “you are investing and price does not really matter”.

Footnotes

1. This is an example, not an actual, viable strategy.
2. Shorting is inherently dangerous, and shorting a volatile index like the VIX is doubly so. The short VIX strategy is an example, not an actual, viable strategy.