Nine Recommendations for Dealing with Stock Price Volatility

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

The same applies to investing.

So, how should we face the present and the future? This article mainly reviews some thoughts and insights shared by investment masters on the public account in the past. At critical moments, these classic sharings and quotes may provide us with deeper reflections and understanding.

I. Understanding Psychological Cycles: The Key Lies in Human Psychology and Emotions

We all know that cycles are inevitable. In the investment world, it is not only crucial to study fundamental cycles but also psychological cycles. This is because, more often than not, what matters is not the data or the events themselves, but how people interpret the data or events—and their interpretations fluctuate as their psychology and emotions swing.

The two extremes of the emotional pendulum swing between 'perfectly wonderful' and 'hopelessly terrible,' with hardly any pause at the 'center point of rationality' (i.e., absolute rationality and reasonable valuation). When the public’s sentiment is blindly optimistic or extremely pessimistic, the likelihood that current price levels and trends become unsustainable increases. The cycle repeats itself.

II. What Drives 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 during 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 significant factors driving market volatility. China’s market cycles exhibit characteristics similar to those of the U.S. market: 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.

III. Try Buying Stocks When They Are Unpopular

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

However, they both favor an investment strategy: trying to buy stocks when they are overlooked, especially during times of crisis, and only purchasing companies that you understand well and are of high quality.

IV. Nine Recommendations for Dealing with Stock Price Volatility

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

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

Second, ensure that you can 'survive' under any circumstances without affecting your quality of life. If a sharp decline next week would lead to financial ruin or emotional collapse, you need to make some adjustments.

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 a decision.

Fourth, if your investments affect your family's life, communicate openly with them, seeking 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 intimate, fame or the self? Which is more valuable, the self or material wealth?'

Sixth, prevent two types of ailments. Avoid falling into 'information addiction'—frantically consuming all kinds of news, analysis, and opinions; and avoid 'stress-induced hyperactivity'—the compulsive need to do something just to feel better.

Seventh, do not try to be overly clever, including attempting to short sell, trade in segments, or leverage at the bottom. Howard Marks said, 'When there is nothing that needs to be done, mistakes often come from showing off your cleverness.'

Eighth, reduce meaningless communication. Most people cannot detach themselves from group sentiment, and excessive communication only reinforces the emotional contagion of the market. "Excessive talk leads to exhaustion; it is better to maintain a balanced approach."

Ninth, if you have not made mistakes, if you are rational and cautious, if your account can survive under any circumstances, if your quality of life will not be affected by stock prices, and if you possess sufficient patience—then, you can try telling Mr. Market: 'Go to hell.' This is the reward you deserve.

Fifth, in extreme periods, the secret to making money lies in contrarian thinking.

So, how should one operate during extreme periods? Howard Marks believes that the key to making money during such times lies in contrarian thinking rather than blindly following the crowd. When emotional investors hold extreme views about the future of an asset, thereby pushing its price to unreasonable levels, simply acting against the trend can often lead to easy profits. However, this is fundamentally different from always opposing the consensus. In fact, most of the time, the consensus reflects the closest approximation to correctness that most people can achieve. Therefore, to succeed in contrarian investing, one must understand:

(1) What the masses are doing,

(2) Why they are doing it,

(3) What problems exist with their actions, and

(4) What alternative actions should be taken and why.

Additionally, renowned financial scholar Michael Mauboussin offers contrarian investors a new perspective: think in reverse. Your advantage may stem from the inefficiency or ineffectiveness of other investors.

This primarily focuses on four aspects:

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

Second, regarding analytical effectiveness: when all investors have access to the same or similar information, but one investor can analyze this information better than others, differences in analytical efficiency will arise.

Third, there is the effectiveness of information—whether effective information can be obtained and whether there is an understanding of that information.

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

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

Investing is a game that balances finite and infinite play. Investors who view investing as a finite game often enter the market with a 'get-rich-quick' mindset, only to unknowingly become mired in it, stretching what was meant to be a finite game into an endless one, tormented by countless short-term fluctuations. Long-term investors, on the other hand, see investing as an infinite game, not focusing on individual wins or losses but striving for long-term survival and sustained performance, with long-term returns being the outcome. How can one become a successful long-term investor? There are three core principles:

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

Second, diversify risk exposure, reduce the impact of single risks, and minimize the effects of black swan events.

Third, over the long term, you don’t need the perfect strategy, but rather a good strategy that you can stick to during difficult times.

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

AI Positioning Advisor!One-click insight into holdings,Full grasp of opportunities and risks

Editor/joryn