Credit Suisse global financial strategies head Michael Mauboussin has put together a checklist to make your first reaction to falling prices rational instead of reactionary
Value investors will tell you that if you can’t stomach volatility, you shouldn’t be managing your own investments, but if you don’t have a plan for what to do when one of your positions starts falling like a knife you’re setting yourself up for failure. To help investors make quick, rational decisions in the face of a sudden drop Credit Suisse managing director and head of Global Financial Strategies Michael Mauboussin has put together an easy checklist, not as a replacement for fundamental analysis but as a stop-gap until your emotions subside a bit.
“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,” writes Michael Mauboussin.
Mauboussin analyzed 10% price drops going back to 1990
To put together his checklist, Mauboussin started by looking at stocks that lost 10% or more of their value in a single day between 1990 and June 2014 and measured their cumulative abnormal returns 30, 60, and 90 days out (he uses the stock’s beta with S&P 500 returns to calculate expected returns). He splits up the results into a few different categories (too many would make the sample size too small to be useful) so that investors can quickly match the stock they hold with the different base cases in his charts. Mauboussin warns that the standard deviations for each category are typically 35% – 45%, but at least the average can give investors some idea of where they stand before they get a chance to reassess their investment in detail.
Four questions to answer before deciding what to do
The checklist itself is just four questions that you need to answer about the stock:
- Was the drop preceded by an earnings event?
- Did the stock have strong, weak or neutral momentum before the price drop?
- Is the stock valuation cheap, expensive, or neutral?
- Is the company high, low or neutral quality (measured by cash flow return on investment)?
The first question tells you which chart you’re going to use, and the next three take you through a tree diagram of average returns (with sample size so you can decide how reliable they are). Again, this isn’t meant to be the final word on whether you should buy or sell, but in a moment of panic it’s better than letting emotions takeover.
See full PDF below.