I can’t remember when I first heard the phrase that is the title of this article. But I’m fairly certain it’s been around for a while and was first used as an analogy relating investor behavior to the stock market. Whether or not the analogy was originally intended to be used as an investing lesson or not is immaterial because it works just fine as one. Essentially, the phrase means that the intelligent investor should be prepared ahead of time for suboptimal conditions. That means that wise people are usually prepared ahead of time for foreseeable events like the inevitable ups and downs of the stock market. I don’t mean to imply that wise people can time the market, I just mean that they know that stock market volatility is a permanent condition in one form or another and they know how they plan to deal with it.
Since we mortals can’t control the markets, the best that we can hope for is to control our own behavior during those inevitable corrections and bear markets that absolutely will occur from time to time. The best way to eliminate the emotional reactions that usually lead to subpar investment results is to make a plan when market conditions are good. By having a sound risk management plan in place in the sober light of day (read good market conditions) astute investors should know what steps if any they will take during future market down turns.
In my opinion, the best tool for fighting against the emotional tug of war between fear and greed within one’s self is to start by working with an experienced financial advisor to develop a sound plan for investing one’s hard earned investment capital. However, a simple financial plan with a spending budget and an asset allocation that looks right on the surface usually isn’t enough. Investors should go the extra mile and understand what the expected downside risk and the long term expected return of the chosen asset allocation and investment holdings are (within certain confidence intervals). Most people build their portfolio based on nebulous terms like ‘I’m a conservative investor’ or ‘I don’t mind taking extra risks to attempt to get higher returns.’ Expected risk and expected return need to be measured and evaluated on a regular basis. Anything less tends to cause investors to assume extra risk at market tops and panic and sell out at market bottoms.
I’ve seen long term investors suddenly turn in to short term traders many times over the years because they took on more risk than they realized they were taking on or they were overly optimistic (usually at market tops). The only thing is that by the time long term investors make metamorphosis from investor to trader, the real traders have long been in cash. It’s about the time that these new traders are selling out that the real traders are licking their chops to get back in. Therefore, it’s a good idea to know ahead of time where you will plan to take profits and cut losses and what your true risk tolerance is. If you have planned ahead to ride through 10% fluctuations in the value of your portfolio, then don’t liquidate everything after a 6% drop. In short, plan your trade and trade your plan.
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