I've recently suggested that investors not watch the market too closely. True, I think it's extremely important to follow developments that affect the stocks and funds you own. But when the markets are as choppy as they've been lately, watching every downward lurch and attempt at recovery can keep you up at night. It can cost you money, too, especially if loss aversion gets the best of you, and you're tempted to sell on one of those downward lurches.
Things go up, things come down
As Benjamin Graham famously said, Mr. Market has good periods and bad periods. There are extended stretches where the market as a whole goes up, and there are (usually less extended, but more dramatic) periods where the market as a whole goes down. Your portfolio may gain or lose significant amounts of value, even if the conditions that seem to be causing the market's movements have no effect on the fundamentals of your investments.
But watching those swoons and lurches too closely can fake you out. Every time the market takes a nosedive, a few more individual investors (and in all fairness, pros, too) panic and sell at a loss.
For example, the declining housing market initially affected homebuilders like Beazer Homes (NYSE:BZH) and Toll Brothers (NYSE:TOL). Then, as the subprime crisis evolved, mortgage providers like Countrywide Financial (NYSE:CFC) were hurt, and financial firms Goldman Sachs (NYSE:GS) and Bear Stearns (NYSE:BSC) also suffered.
Yet now, those incidents have eroded confidence in the markets (and the economy) as a whole. So stocks like Ford (NYSE:F) and Wal-Mart (NYSE:WMT) with no obvious connection to housing have nonetheless gotten dragged down. And while Wal-Mart arguably has other fundamental issues that could be affecting its stock price, Ford is down 20% since the beginning of July, despite increasing evidence that its global turnaround plan is taking hold. If you're a Ford investor, that dip could be spooky enough to cause you to question your judgment.
So why not walk away for a few months? You bought the stock planning to hold it for a year or longer, right? Sure, listen to the quarterly conference calls and maybe scan the headlines every week or two, but don't look at every movement in the stock price and drive yourself nuts recalculating the value of your portfolio every night. Maalox really isn't that tasty, after all, is it?
Great investors have bad days, too
Derivatives trader Nassim Nicholas Taleb, in his excellent book Fooled by Randomness, makes an important point about watching the markets too closely. He offers an example of a skilled amateur investor who can be expected to earn, on average, 15% a year beyond the rate of return on Treasury bills, with a 10% error rate (i.e., volatility). According to Taleb's calculations, this hypothetical investor has a 93% chance of "success" -- returning more than Treasuries -- in any given year. Sounds pretty good, doesn't it?
But if you look at his results over narrower time scales, the picture isn't as good. In fact, as you shorten the time frame over which you look at results, the probability that this hypothetical investor will succeed over that span goes down. From minute to minute, Taleb says, he has a slightly better than 50% chance of being successful, a 54% chance on any given day, a 67% chance in any given month, and a 77% chance in every given quarter.
So if this investor looks at his portfolio every day, here's what he sees: Some days he's up, some days he's down. The number of up days exceeds the number of down days, but not by very much -- there are still plenty of down days. And some of those down days will no doubt look very ugly.
Yet this guy is a star investor, with a great track record -- we know that, because we've defined him that way. Still, he has almost as many down days as ups.
The moral of the story
All investors, even the really good ones, have lots of days when their portfolios are down. Some of those days will be really ugly, just as some of the up days will be really excellent. If the market's current cycle of gyrations is stressing you out, and you're finding yourself tempted to throw up your hands and sell, take a break from watching it. Remember Taleb's example: Even the best investors have lots of down days. And remember that investment success is best measured in years and decades, not days and weeks.
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Fool contributor John Rosevear does not own any of the stocks mentioned in this article. Wal-Mart is an Inside Value pick. The Motley Fool's disclosure policy, like Tom Petty, knows that the waiting is the hardest part.
