If you strongly believed that the market was going to undergo a significant correction soon, what action would you take?
Obviously, you'd want to sell your stocks and maybe even initiate some short positions. After all, the smart thing to do if you see danger on the horizon is to take action.
That sounds simple enough, but is it really the best approach to take with the stock market?
Well, the big problem with such moves revolves around timing. You can be absolutely correct about some major market disaster, but if your timing is off, then you might as well be wrong. As the economist John Maynard Keynes once famously said: "Markets can remain irrational longer than you can remain solvent."
So, what do we do when we can't shake our fears and doubts about the market but are also afraid that if we anticipate too much, we'll miss out on gains? And what if it turns out that we're just plain wrong about the market falling apart? How do we protect ourselves in such instances?
I believe it all boils down to the debate between "anticipating" and "reacting." If we anticipate in a very timely manner, we're going to do quite well compared to those who are slow to react to a market change. And if we react quickly as the market's character shifts, we'll be far ahead of those who've anticipated such action for weeks or even months.
But before deciding whether to err on the side of anticipation or reaction, we need to acknowledge one great truth: No one is able to consistently time stock-market turns with great precision.
Many traders and investors claim that they can play the market's ups and downs like a piano, and some are even lucky and nail the turns correctly at times. But no one -- and I mean no one -- can do so consistently over a long period of time.
But despite the lack of positive results, calling the market's "turns" is one of Wall Street's predominant topics of discussion. In fact, probably half of the verbiage produced about stocks would disappear if we didn't talk about market turns.
People want to nail the market's exact turning point, which is why so many players are anticipatory rather than reactive. They've come to believe that if you're late, you're wrong -- but that if you're early, you're never wrong.
Far more people anticipate rather than react because it's more satisfying to have a chance to get it exactly right. By contrast, you'll always be less than perfect if you react. You'll always be late, and you can never brag about "nailing" a precise market top.
Predicting crashes or major turns makes people feel smart, and the media love to promote dramatic predictions. In fact, there are many market gurus who've lived for years off of one big, lucky prediction and have never been close to right again. So, there's great pressure to be anticipatory about the market rather than reaction-oriented.
But you're interested in actually making money, there's only one question that matters: "Is the cost of anticipation higher than the cost of reaction?"
Like most things in the market, there's no simple answer to that. It all depends on implementation and luck. You'll be lucky at times, and that plays a big part of it. But I suggest that most traders would be better off if they focused on being more reactive rather than anticipatory.
Anticipatory traders never seem to talk about the opportunity costs of being early, nor the outright losses they'll face if they short prematurely. You'd think these folks were always completely long or short at the exact minute that the market turned. And inevitably, they're praised for their "accurate" predictions by those who've been hoping and praying for a shift in the action.
By contrast, reactive traders are viewed as less insightful than those who constantly make predictions. The reactive trader doesn't sit around concocting a thesis about why some sort of change is inevitable. Instead, he or she simply sticks with the trend until there's some reason not to.
Too often, traders do things for emotional and psychological reasons rather than because of what makes the most sense financially. They often make predictions or anticipatory turns simple because they think that's what they're supposed to do.
But correctly being anticipatory has become more and more difficult in our current market environment. The market has consistently produced V-shaped moves and traded in a "straight-up" fashion far more often than seems reasonable.
As a result, those who keep trying to call turns have consistently been far too early. Not only do they suffer losses on their shorts, but they miss out on all sorts of the gains as momentum continues to run in one direction.
Traders always have to work to find a style that suits their personalities, but it's extremely important to consider whether you want to err on the side of anticipation or reaction. If you're consistently too early, is that because you place too much emphasis on making a big call? Would you better off if you used trailing stops and only sold on weakness?
The bottom line: Anticipation and reaction are at the core of trading styles. Make sure you're aware of your bias.
