I learned to think of this phenomenon as analysis paralysis, because when it happens to me I get so caught up in weighing pros and cons, or looking for that one little piece of information that will make my decision obvious that I never actually make a decision.
I think one of the most dangerous times analysis paralysis can show up is when you’re trying to figure out if the market is at or near a major reversal point. It’s quite a different thing, making a decision about where to put your money when the market is moving along a clearly defined trend, than it is when the market might be getting ready to reverse in one direction or another. At these points, second-guessing ourselves becomes much easier, and it seems to be more natural to think about what you might be missing out on when your decision takes you in a certain direction.
The problem with trying to evaluate something like opportunity cost is that in the stock market, it’s almost impossible to quantify. Opportunity cost is a forward-looking concept, and the only way to measure the stock market in practical terms is on a historical basis (and as we all know, “previous results don’t guarantee future returns”). Conservative investors who believe the market is about to reverse off of historical highs might be tempted to start moving their money out of stocks and into cash because they don’t want to be caught on the wrong side of a new downward trend. The problem is if – if the market reverses and starts to drop quickly, they’ll be better off than everybody else. But if they’re wrong, and the market keeps going up, they’ve sacrificed a completely unknowable amount of continued profits.
The same problem exists on the opposite side of the question. If you want to try to stay in the market for as long as possible to maximize your gains, you are at an increasing risk of being on the wrong side of things when a major market reversal comes. Staying in means you could keep making money, if the market keeps pushing your stocks higher. It also means you could lose all of the gains you might have made so far if the market reverses quickly against you. So where is the highest opportunity cost? In more than two decades of market and investing experience, I have yet to solve this particular problem. I don’t think anybody really ever has. The problem is that if you dwell on the question too much, you’re probably never going to be able to make a practical, useful decision.
How do I deal with analysis paralysis, especially when I think the market is at increased risk of a major market reversal, and given that I know I won’t always make the right decision? When it comes to investing, I think inaction is the worst thing you can do. I don’t mean that you forge ahead and ignore risks when you can see they are there, or that you shouldn’t lessen your exposure to the stock market in these kinds of situations. Sitting in cash, if you feel that is best place for you right now, doesn’t exactly fit my description of inaction, either. To me, inaction is letting yourself get paralyzed by conflicting information to the point that you do nothing.
The longer I invest in and study the markets, the more I realize that there really never is a perfect picture or set up. I can always find information that will contradict a direction I want to go. That’s true no matter whether I’m talking about broad market conditions or an individual stock to use for a put sale. If I let them, those contradictions will paralyze me and keep me from making a functional decision that will help me keep making money. As much as possible, then I try to look for a preponderance of evidence to lead me in one direction or another. If there are clearly more positives in a stock’s fundamental and value profile than there are negatives, for example, it’s pretty easy to justify making a trade, even though the stock might not fit all of the criteria I prefer to use.
Analyzing broad market conditions is usually quite a bit messier than analyzing a single company, and so finding a preponderance of evidence one way or another isn’t usually as straightforward. That’s why i strongly believe in position sizing and reducing of risk using options. It makes sense to implement more conservative rules about the investments you make and how you will manage them when you think overall market risk is increasing. The advantage those conservative measures gives you is the ability to keep letting the market work for you. Working with stocks that are already priced at levels that make them a bargain is another way to keep working with the market without running the risk most investors are when they buy stocks that are overextended and overpriced. It doesn’t mean we don’t take market risk, but I think it does give us a way to deal with it, and avoid having analysis paralysis hamstring our ability to make good decisions along the way.