Florence L

The Better It Gets, The More Cautious You Should Be

Florence L
The Better It Gets, The More Cautious You Should Be

We are going to attempt to explain why this is the case. Why shouldn't you chase a hot market? Let's take a look at the graph below. Basically once you get the idea behind this simple graph, you will learn to avoid hot markets, both because of its risks (to collapse just as quickly), and also because if it's already hot, your chances of earning a high return is less unlikely. 

Think back to financial disasters such as the housing crisis and the dot com bubble. Prior to the "bubble bursting", it seems that elevated market excitement can be seen everywhere. People can't wait to throw money into the hot stock/money/housing/startup market. Months to a year later, these same investors are shocked by the collapse of the certain market they had invested into. Is it really that big of a surprise? Not really. Just observe some of the rules passed on to us through various disciplines. 

Reversion to the Mean || Finance

There are peaks and troughs (highs and lows) in the market, and the mean is the mean or average of the market. According to this rule, things have a tendency to revert to the center. If you look at he graph below, it shows that even if though the market seems to have climbed over the past several years, it took several cycles of the price/number reverting back to somewhere a bit higher than the mean/average point. 

 Regression to the mean: If the blue line is the mean, the blue line oscillates up and down around it. The trend moves above the average, then regresses back towards it, often overshooting up and down.

Regression to the mean: If the blue line is the mean, the blue line oscillates up and down around it. The trend moves above the average, then regresses back towards it, often overshooting up and down.

Back To Equilibrium || Economics

Economics 101 teaches us that there is an invisible hand that guides the market, which miraculously directs factors within the market (simple factors would be supply and demand) to balance at an equilibrium point. If you think of a see-saw, the equilibrium point would be the balance point when it sits still and level, not leaning towards either side. Again, a theory that revolves around factors gravitating towards a center point. Perfect Segway into the next theory. 

What Goes Up Must Come Down || Gravity

Perhaps this should be the easiest to understand and is also the oldest guiding rule in the book. What goes up must come down.  Throw an apple up and it will fall back down the ground. Easy right? Now apply this idea to markets. Markets go through recessions and inflation periods (highs and lows, up and downs, however you want to refer to it), whereas stocks can ascend quickly because of favorable news and tank just as quickly with negative news. 

So the three common laws and theories we read above, which is common knowledge during our school years, should be a big hint that if something looks really, really good, and has been really, really good for a while, our defense mechanism should kick in and we should prepare ourselves for the troughs approaching soon. 

How About That Black Swan?

Economics 101 teaches us that there is an invisible hand that guides the market, which miraculously directs factors within the market (simple factors would be supply and demand) to balance at an equilibrium point. If you think of a see-saw, the equilibrium point would be the balance point when it sits still and level, not leaning towards either side. Again, a theory that revolves around factors gravitating towards a center point. Perfect Segway into the next theory.