The Investment Scientist

Juggling Investment Odds

Posted on: March 6, 2012

Investors crave certainty, but the future is never certain. Prudent investment requires juggling odds. Here are the types of odds that go into my decision making process.

January Barometer Effect

When the market records a positive return in January, the odds that it would record a positive return for the rest of the year are 90%. If not, the odds drop to 50%. This January, the market had a positive return.

Seasonal Effect

Historically, November to January is the best season for the market. This coincides with major holidays and excessive booze consumption. February to May is usually the sobering period when the market gradually lost momentum. June to October is known for fear and volatility when the trashes (aka bad economic and corporate news) that were swept under the rug during the holiday season are finally taken out.

The odds that market goes up between Novembers to May are 90%; the odds the market goes up between June to October drop to 50%. There is not economic explanation, but there is an anthropological explanation that I just gave.

Correction Probability

It’s a rule of thump that a 10% market drop happens once a year almost surely. A 20% drop happens every 3 years; 30% drop every 10 years; 40% drop every 20 years and 50% drop 50 years.

Since we had a 50+% market drop three years ago, the odds of a 40% and 50% drop are rather remote. 30% drop possible but not probable. However, we most likely will get a 10% somewhere this year, probably a 20% drop.

A 20% drop is not unfathomable whenIsraelattackIran. When that happens, remember it’s not the end of the world, and we want to use the opportunity to pick up equities cheap with rebalancing.

If a client starts with me today, I will be very cautious in deploying his money since we are entering into the sobering period of the market and a market correction is just off the horizon. However, all we deal with here are odds. Nothing says the market can’t have a great summer season and that it avoids correction this year. Nothing says there can’t be a black swan somewhere that drops the market by 50%.

Whatever may happen, always take money off the table when markets go up a lot and do the opposite when they go down. That can be accomplished by disciplined rebalancing.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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