CMU: The biggest way people screw up market meltdowns (besides freaking out)

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CMU: The single biggest way people screwup market meltdowns (besides freaking out)

Generally speaking, there are two main groups of people in the market, long-term investors and short-term traders. One person buys stocks at attractive prices, holds for multiple years, and profits when the rest of the world finally figures out what they knew a long time ago. The other person takes advantage of daily price swings and will hop in and out of the market countless times a year. The one thing they have in common? They both screwup market meltdowns (but in the opposite way).

First, the long-term investor. He plans to hold for long periods of time and ride through these periodic gyrations. He doesn’t care what the market is doing now, only where it is years from now when he sells. Or at least that is what he is supposed to do. Unfortunately, it doesn’t always work out that way.

All too often, these long-term investors follow the news a little too closely. They read headlines screaming Coronavirus, bank defaults, rate-hikes, socialists, or any of the countless other reasons investors fret. Once prices start crumbling, their confidence cracks and they start wondering if they should be worried. Prices fall a little further and that wonder turns to fear. A little lower and panic sets is. Long gone are thoughts of holding for the long-term and now all they can think about is watching even more of their net worth evaporate. If they don’t act now, things will only get worse. There is no greater fear than the fear of regret and finally, the confident long-term investor turns into a fearful seller.

Of course, by the time the long-term investors reaches his breaking point, stocks have fallen a long, long way. In fact, they have fallen so far that often they are not far from the ultimate capitulation bottom and rebound. But he doesn’t know that. All he knows is he wants to get out and he won’t be able to sleep until he does.

Now for the short-term trader. He darts in and out of the market with the greatest of ease. Things like market meltdowns don’t bother him. In fact, he roots for them because he thinks they are a great way to make big profits. Unfortunately, it doesn’t work out so well for many of them. It starts out well enough. The market dips like it has a thousand times before. Buy the dip, sell the bounce, repeat until wealthy. But this time, the dip doesn’t bounce when it is supposed to. Well, that’s okay, he got in a little early and all that means is he needs to wait a little longer before the bounce. But the next day, price falls even further. Now things are definitely not looking good. But he tells himself he can manage this, he doesn’t want to be that guy who loses his nerve and sells moments before the inevitable bounce, so he keeps holding. But rather than bounce, the market tumbles again the next day. Now his losses are so big he has no choice but to keep holding. Everyone knows it would be foolish to sell at these levels. He should be buying this dip, not selling like all the other emotional cowards. And yet, prices keep falling and he keeps holding.

Long and short-term investors get killed in market meltdowns because they change their plan in the middle of the trade. The long-term investor loses because he sells too quickly, the short-term trader fails because he holds too long. As the old cowboy saying goes, never change horses midstream. Your trading plan should always account for the inevitable market meltdowns. If your plan is to ride through them, ride through them. If your plan is to get out and go short, get out and go short. Don’t be that guy who reacts emotionally, changes his plan halfway through the trade, and does the exact wrong thing at the exact wrong time.

It’s a market cliche and it sounds corny saying it, but “plan your trade and trade your plan.” There is no more valuable piece of advice a trader can receive than that.

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