Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).

H/T Meb Faber

Summary

  • 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.

Michael Mauboussin: Managing the Man Overboard Moment – 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.2 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.

Michael Mauboussin Stock Price Declines 1

Michael Mauboussin: Structure of the Analysis

There are two broad approaches to making a decision. You can rely on the specific circumstances of a particular situation as well as your own experience. This is known as the inside view. Or you can examine a larger reference class to understand the base rates. This is known as the outside view. For example, if you are forecasting the returns for the stock market in the next year you can use the inside view to come up with an estimate based on current valuation, sentiment, and your own gut feel. Or you can use the outside view and examine how the stock market has done over the years. Both the inside and outside view are useful, and there is a specific way to combine the two to allow for an effective forecast.5 But research in decision making suggests that we naturally rely more on the inside view than we should.6 In fact, it is common for investors to be unaware of the base rates that are relevant in their decisions.

We use base rates to show how stocks perform after they have dropped sharply. To do this, we calculate the “cumulative abnormal return” for the 30, 60, and 90 trading days after the time of the decline. An abnormal return is the difference between the total shareholder return and the expected return. A stock’s expected return reflects the change in a broader stock market index, the S&P 500 in our case, adjusted for risk. The cumulative abnormal return, then, is simply the sum of the abnormal returns during the period that we measure.

See full PDF below.