Don't Be Fooled by Randomness

It's hard for me not to look at my portfolio all the time. Modern technology makes it easy to see how much my stocks are worth, to the penny, at any given second.

But I keep trying to ignore those daily fluctuations. So should you. It's not just distracting to obsess over the daily volatility in our portfolio -- it's actually detrimental to our performance.

Ignoring the noise
As investors, we often fail to understand the extent to which short-term price movements in stocks are utterly random. People buy and sell stocks for hundreds of reasons that have absolutely nothing to do with their intrinsic values.

Imagine that Dr. Carey owns 10,000 shares of Income Investor pick JPMorgan Chase (NYSE: JPM  ) , because he's heard a lot of good stuff about that Jamie Dimon guy, and he likes the dividend yield.

One day, while eating his morning toast, Dr. Carey reads a newspaper article about problems at Citigroup (NYSE: C  ) with its structured investment vehicles (SIV). That sounds very bad, and JPMorgan's stock price has been weak lately. Dr. Carey subsequently calls his broker and asks to sell all of his JPMorgan stock.

Individual investors gone wild
If there are enough "Dr. Careys" out there, it can hugely affect a stock's price, even though JPMorgan has no SIV debt and just posted an extremely solid quarter. (In fact, JPMorgan's stock is down nearly 10% year to date.)

In the long run, however, these bursts of irrational selling are meaningless, and the stock price usually returns to its true intrinsic value over time.

Mental institutions
Individual investors aren't the only ones to blame for irrational behavior. Large financial institutions, with their billions in assets and trigger-happy managers, can cause huge stock-price distortions.

You can see this phenomenon especially in the rise of quantitative funds. In essence, these funds buy and sell billions of dollars in stocks every day, simply because a computer tells them to. In addition, fast-money hedge funds account for a huge portion of daily trading.

Other factors contribute to the noise of daily stock prices. For example, Dillard's (NYSE: DDS  ) and Big Lots (NYSE: BIG  ) are two relatively obscure retail stores far from the radar screens of many investors. I'd be surprised if five out of 100 people in Japan had heard of those companies. However, millions of people around the globe trade in their shares everyday -- simply because they belong to the S&P 500 index.

Feel the noise!
Although it's annoying to see a stock we just bought get a 5%, 10%, or even a 15% haircut for no apparent reason, it's important to put that drop into the proper context.

If you just filled up half your tank with gas, and then the gas station owner came out and offered you a 15% discount on the rest, would you be happy or upset? If I told you that you could buy a stock, and in three years it'd be up 100%, but it'd initially go down 20%, would you still want to buy it? Even the best investors can't pick exact troughs in a stock's price. Warren Buffett's investments in Inside Value recommendation USG (NYSE: USG  ) and Washington Post (NYSE: WPO  ) each took severe drawdowns of more than 25% before rebounding. 

It's amazing how fervently investors -- myself included -- hope a stock will go down right before they buy it, and then obsessively wait for it to skyrocket the second after they buy. If we liked the stock at $10, shouldn't we like it even better at $9? Great investors realize this, and often buy more shares when the price falls. On the other hand, mediocre investors often confuse price and value, selling their stock into the noise and taking losses.

The bottom line
Volatility happens, and investors just need to accept it. Fools, ignore meaningless daily fluctuations in the stock market, and concentrate on the long-term picture. After all, you'll never catch any big waves if you're too obsessed with the ripples.

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