- A key part of successful investing is the ability to keep emotions in check in the face of adversity.
- A particularly challenging situation is when a stock in your portfolio drops sharply, an event that precipitates what has been called a “man overboard” moment.
- This report provides analytical guidance if one of your stocks declines 10 percent or more in one day. Such drops tend to evoke strong emotional reactions and make sound decision-making difficult.
- We provide the base rates for more than 5,400 such events in the past quarter century. We refine the base rates by separating earnings announcements from non-earnings announcements and by introducing factors including momentum, valuation, and quality.
- We provide a checklist to guide you as you decide whether to buy, hold, or sell the stock.
Introduction
A key part of successful investing is the ability to keep emotions in check in the face of adversity. One example, the focus of this report, is when one of the stocks in your portfolio drops sharply.
If you are the portfolio manager, you might feel frustrated, upset about the hit to returns, and worried about the business implications. If you are the analyst, you might feel anger, disappointment, and shame. None of those feelings are conducive to good decision making.
This kind of event precipitates what has been called a “man overboard” moment.1 These moments demand immediate attention, are stressful, and require swift action. In an investment firm it is common for a number of professionals to stop what they are doing in order to discern a suitable course of action. The use of a checklist is one approach to making good decisions under pressure.
In his superb book, The Checklist Manifesto, Dr. Atul Gawande describes two types of checklists. The first is called DO-CONFIRM. Here you do your job from memory but pause periodically to make sure that you have done everything you’re supposed to do. The second is called READ-DO. Here, you simply read the checklist and do what it says. READ-DO checklists are particularly helpful in stressful situations because they prevent you from being overcome by emotion as you decide how to act.
You can think of your emotional state and the ability to make good decisions as sitting on opposite sides of a seesaw. If your state of emotional arousal is high, your capacity to decide well is low.
A checklist helps take out the emotion and moves you toward a proper choice. It also keeps you from succumbing to decision paralysis. A psychologist studying emergency checklists in aviation said the goal is to “minimize the need for a lot of effortful analysis when time may be limited and workload is high.”
The goal of this report is to provide you with analytical guidance if one of your stocks declines 10 percent or more in one day. More directly, we want to answer the question of whether you should buy, hold or sell the stock following one of these big down moves.
Exhibit 1 shows the number of such observations from January 1990 through mid-2014. There were more than 5,400 occurrences in all, with clusters around the deflating of the dot-com bubble in the early 2000s and the financial crisis in 2008-2009. The bubble periods contain about 40 percent of the observations. These sharp drops happen frequently enough that they deserve a thoughtful process to deal with them but infrequently enough that few investment firms have developed such a process.
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