The Pullback

The Nikkei and Topix had a rough week as they lost -1.7% and -2% respectively. The pullback this week was on light volume ahead of Easter as well on the back of some geopolitical tensions, which 6 months from now we will probably just be categorizing as noise. In any event, the pullback did make me think of the dilemma that the Long Only fund manager faces during such pullbacks. 

Stocks that you've done your homework on and feel confident in are now in free fall and you have to make a decision. The first option is to do nothing and wait for the market and your stock, to hopefully recover. On so many levels, this is the correct course of action and is what separates a professional investor from a retail or amateur investor, who is instead guided by raw emtions and whatever the latest hedlines are. 

However, herein lies a problem. Your stock is correcting with the market and as it's correcting, it may be slightly outpeforming or slightly underperforming its benchmark. Therefore, you could potentially have a long drawn out correction (3 to 6 months) and unfortunately also be forced to underpeform during the entire time simply because you made the decision to stick to your guns. What I'm saying here is certainly not new or earth shattering, but I would pose another thought as well on this point. 

As the general market and your stock pulls back, your rationalization of what is happening creates a feedback loop. You've rationalize that your stock is down because the market is down and that really is true. However, this rationalization also breed another problem which is rigidty. In other words, I have rationalized the movement in my stock because of the market, which then unconsciously also strengthens my belief that my stock is still a good stock. And this is where the next major problem develops.

Your stock is down, the market is down, your underpeforming and you've done your homework. You're not getting emotional and your now even more committed to the idea that this stock is the right stock! However, your next problem is that as the market stabilizes and then eventually begins to advance higher, there is a VERY high probablity that the dynamics in the market have completley changed during this correction and that the next up cycle will have a new set of leading stocks! I find this happens more frequently in the US market than it does in Japan, but it does happen here quite a bit as well. The point is the same however, and that is that the fund manager faces a VERY difficult dilemma of staying the course with a stock that has gone sour in the eyes of market, or, relaize the the loss and then hope that you can correctly identify what sectors and individual stocks will be the new leaders during the next upturn.

There are obviously no easy answers when it comes to experiencing and sitting trough corrections. However, the biggest risk for all investors (and certainly not just professional pm's), is the risk of rigidity where one correct decision to stick with your stock during a correction then unconsciously biases your next decison of what to do when the market is turning up and your stock is not outpeforming. I certainly don't want to suggest that it is always correct to switch stocks midstream, however, by simply realizing that this bias exists may help you make better and more informed decisions when you experience the "pullback!"