Nine Suggestions for Dealing with Stock Price Volatility

Napoleon's definition of military genius is 'a person who can continue to act rationally when everyone around them has become irrational.'

The same applies to investment.

So, how should we face the present and the future? This article mainly reviews some thoughts and reading notes shared by investment masters on the official account in the past. At critical moments, these classic shares and quotes may offer us deeper insights and reflections.

1. Understanding psychological cycles: What matters are human psychology and emotions.

We all know that cycles are inevitable. In the investment world, it is not only essential to study fundamental cycles but also psychological cycles. Because often, what matters is not the data itself or the events, but how people interpret the data or events. And these interpretations fluctuate with changes in psychology and emotions.

The two extremes of the emotional pendulum swing between 'perfectly flawless' and 'irredeemably bad,' with almost no pause at the 'center point of happiness' (i.e., absolute rationality and reasonable valuation). When public sentiment becomes blindly optimistic or extremely pessimistic, the likelihood that current price levels and trends are unsustainable increases. The cycle repeats endlessly.

2. What are the driving factors behind stock price increases?

For fundamental research investors, from a long-term perspective, the most important source of market returns comes from the value creation of listed companies themselves. However, in the relatively short term, or across different market phases, what drives stock price increases? We attempt to explain the drivers of stock prices using modern financial theory: Stock Price = Price-to-Earnings Ratio * Earnings Per Share (P = PE * E).

In other words, stock prices can be broken down into two components: earnings and valuation. Among these, fluctuations in valuation are one of the most important factors driving market volatility. The market cycles in China and the United States exhibit similar characteristics: During periods of hope, valuations rise; during growth phases, earnings increase; and during optimistic periods, valuations rise again. Liquidity is a key factor driving fluctuations in valuation.

3. Try buying stocks when they are out of favor.

No one can precisely and consistently capture the ups and downs of market trends, not even world-class investment masters such as Buffett, Graham, Soros, or Templeton. This is because there simply does not exist a universal rule for investing.

However, they all favor an investment strategy: trying to buy stocks when they are neglected, especially in times of crisis, and only purchasing companies that you understand well and are fundamentally sound.

IV. Nine Recommendations for Dealing with Stock Price Volatility

Even though we know it is crucial to remain rational at critical moments, how should we practically handle the ups and downs of stock price fluctuations?

First, honestly review your investment decision-making process, and if there are errors, acknowledge them as soon as possible. As Duan Yongping said, when correcting mistakes, “No matter how great the cost, it is the smallest cost.”

Second, ensure survival under any circumstances without affecting your quality of life. If a significant drop next week would lead to financial ruin or mental breakdown, adjustments are necessary.

Third, observe your emotions and avoid making major decisions under extreme emotional states. If you are feeling anxious or fearful, it is better to sleep on it rather than make impulsive decisions.

Fourth, if your investments affect your family’s life, communicate openly with them to gain their understanding and support. Do not conceal or deceive.

Fifth, do not persist in an error just to “prove yourself.” As Laozi asked, “Which is more important, fame or life? Which matters more, life or material wealth?”

Sixth, prevent two types of maladies: do not fall into “information addiction” — obsessively consuming news, analyses, and opinions; and do not succumb to “stress hyperactivity” — frantically taking actions merely to feel better.

Seventh, do not act overly clever, including attempting short selling, timing the market, or leveraging to buy at the bottom. As Howard Marks said, “When no action is required, mistakes often arise from showing off one’s cleverness.”

Eighth, minimize meaningless communication. Most people cannot detach themselves from herd sentiment, and excessive interaction only amplifies the market’s emotional contagion. 'The more you speak, the less effective you become; better to maintain inner balance.'

Ninth, if you have not made any mistakes, if you are rational and prudent, if your account can survive under any circumstances, if your quality of life is unaffected by stock prices, and if you possess sufficient patience—then you may try telling Mr. Market: 'Go to hell.' You have earned that reward.

Five: During extreme periods, the secret to making money lies in contrarian thinking.

So, how should one act during extreme periods? Howard Marks believes that the key to profiting during such times lies in contrarian thinking rather than blind conformity. When emotionally driven investors hold extreme views about an asset’s future and push prices to unreasonable levels, going against the grain often yields easy profits. However, this is fundamentally different from simply opposing consensus at all times. In fact, consensus usually represents the closest approximation to correctness that most people can achieve. Therefore, to succeed as a contrarian investor, one must understand:

(1) What the crowd is doing,

(2) Why they are doing it,

(3) What is wrong with their approach, and

(4) What alternative action should be taken instead, and why.

Additionally, renowned financial scholar Michael Mauboussin offers contrarian investors a new perspective: consider this inversely—your edge may stem from other investors’ inefficiencies or irrationalities.

This primarily centers on four aspects:

First, the effectiveness of behavior is low, primarily manifested in the irrational actions of 'Mr. Market': when the market reaches extremes, valuations can easily become excessively high or low. In such cases, it is necessary to make a clear distinction between facts and opinions. Facts are objective and can thus be falsified, whereas opinions are quite the opposite. Both facts and opinions are useful for investors, but facts should take precedence.

Second, regarding the effectiveness of analysis: when all investors possess the same or similar information, differences in analytical efficiency arise if one investor can analyze this information better than others.

Third, the effectiveness of information, which pertains to whether effective information can be obtained and whether there is an understanding of such information.

Fourth, technical effectiveness, which is more related to liquidity.

Sixth, investors should aim to 'minimize future regret.'

Investing is a game of both finite and infinite strategies. Investors who treat investing as a finite game often enter with the mindset of achieving 'overnight wealth,' only to find themselves unwittingly trapped, with the finite game stretching endlessly and being tormented by countless short-term fluctuations. Long-term investors, on the other hand, view investing as an infinite game, not focusing on minor wins or losses but rather on sustaining better performance over the long run, with long-term returns being the outcome. How does one become a successful long-term investor? There are three core principles:

First, taking risks is key to long-term investment success. The amount of risk you can bear is the most important predictor of long-term returns.

Second, it is essential to diversify risk exposure, reduce the impact of single risks, and mitigate the effects of black swan events.

Third, in the long term, you do not need the most perfect strategy but rather a good strategy that you can stick to during difficult times.

Since maintaining absolute rationality and adhering to the most perfect strategy can be difficult to sustain, Markowitz, known as the 'father of portfolio theory,' summarized a more practical investment approach: investors should aim to 'minimize future regret.' This approach aligns better with human nature and is easier to adhere to.

Editor/Jayden