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React, Don't Predict

August 26, 2013 | About:
I am something of an enigma to my neighbors here in Central Florida.

They see me several times a day around the neighborhood either walking our youngest to and from school or taking the dog on one of our daily jaunts around the area. I work from home and have worked these activities into my routine and I suppose it appears like I am either retired or a kept man as my banker wife leaves early for every day for her office.

Sooner or later someone will ask me what I do for a living and almost 100% of the time I get one for both of two questions when they find out I am an investor and newsletter author.

The first of course is, “What did the market do today?" A neighbor asked me the other day and I had to pull out my phone and check. I had spent the day perusing 13F filings of some of the smarter more successful investors looking for ideas I could steal and reviewing balance sheets. I had a good idea where most of my companies were trading but had no idea what the market had done. Unless there is some extreme event that creates opportunities or moves one of my stocks to an overvalued level the daily movements of the are just so much noise to me.

The second question is always, “What do you think of the market?” My stock answer these days is that I try really hard not to think about the market. Predicting the likely path of the stock market is one of the most difficult things to do and engaging in such speculation is usually a waste of my time.

I have been around the markets for the better part of three decades and have met only a small handful of people I have encountered who could predict the stock market. They all had advanced degrees in things like statistics and physics. They have enough computing power to run a mission to Mars and they only make very short-term projections of a few hours or maybe a day out. Anything longer than that is just a guess no matter how well informed they are.

John Kenneth Galbraith gave us one of the best quotes on the subject of predictions. He once said, “There are two kinds of forecasters: those who don't know and those who don't know they don't know.” It is the second type we run across most often in the stock market.

These folks have multistage models and complicated formulas to tell you what the market is going to do over the next year or so. Others have charts with all sorts of lines and squiggles that are supposed to determine the next move in the market. The vast majority of these have a statistical that is only slightly less reliable than a coin flip. Those predictors that have a lucky series of flip become revered prognosticators and gurus until the laws of statistics and randomness eventually catch up to them.

In the finance world we also have a third type of forecaster and they are the most dangerous of all. These forecasters know they don't know but will try to find a series of lucky coin flips to position themselves as experts and sell you on their expertise.

They knew it was random and accidental and don't care as long as they find a way to get paid. They will flip that coin until they get a streak and the get the hype machine into high gear. They are usually the loudest most bombastic predictors and should be avoided if, as I am, you are overly fond of your money.

Over the years I have observed those investors who have made their millions buying stocks and not just collecting management fees to build their wealth. What I found is that they do not predict what the market might do, they react to what it actually does. If the markets are down substantially and participants are depressed they buy a percentage ownership of a business and if the markets are up and euphoric they sell their interest in the company at a premium price.

This concept of react not predict at heart of deep value investing. If the stock market is selling off then more bargain issues are created and my research universe expands. It is in the aftermath of one of the big down moves we see every 5 to 10 years that I am able to find 100s of stocks that are cheap and pass my strict credit and fundamental criteria.

In the annual (or used to be annual as we have not had one in some time) 10-15% correction enough bargains are created that I am able to expand and add to my portfolio. As markets are rising more of my stocks become fully valued and are sold and there are few if any new opportunities to replace them so cash balances rise.

It is a natural timing mechanism that requires no predictions or calculation on my part. It just the market and economic cycle at work.

About the author:

Tim Melvin
Tim Melvin is a value investor, money manager and writer. He has spent the last 27 years as in the financial services and investment industry as a broker, adviser and portfolio manager. He has also written and lectured extensively on the markets with his work appearing on RealMoney.com, DailySpecualtion.com, Benzinga.com as well as several print publication including Active Trader and the Wall Street Digest.

Visit Tim Melvin's Website


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