Roll with the market: How valuations can help investors avoid costly mistakes

Stock market numbers are displayed on the floor of the New York Stock Exchange during morning trading on May 26. Photo by Michael M. Santiago/Getty Images files

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Luck’ll come and then slip away
You’ve gotta move, bring it back to stay
You just roll with it, baby —Roll with It, by Steve Winwood

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One simple truth about markets is that they have, and always will, continue to periodically present investors with dynamically evolving combinations of risk and reward.

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To never suffer losses is an unrealistic objective for those who wish to reap satisfactory returns. It is far more efficient (and financially rewarding) to roll with it. This entails adapting to changes to 1. maximize gains when markets offer above-average returns with relatively low risk and 2. to minimize losses when markets offer below-average returns with above-average risk.

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Yogi Berra and the sine qua non of successful investing

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The Latin phrase sine qua non means “without which not,” which refers to something that is a necessary or indispensable requirement. The sine qua non of successful long-term investing entails constantly assessing and reassessing the magnitude of potential losses relative to potential gains and adjusting your portfolio accordingly.

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Baseball legend Yogi Berra stated, “In theory, there is no difference between theory and practice. In practice, there is.” If you dial up your risk profile when the odds favour doing so and take some chips off the table when the probabilities dictate as such, your long-term performance will inevitably be well above average. So far so good.

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Unfortunately, accurately assessing and reassessing these probabilities as they ebb and flow over time is no easy feat.

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You can’t predict behaviour

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I don’t believe that there is any accurate way to gauge the relative magnitude of upside versus downside risk over the short-term, which I define as a period of at least one to two years.

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People can persist in irrational behaviour for longer periods and with greater voraciousness than might seem possible. In hindsight, most investors should have exercised prudence long before tech stocks reached their peak in early 2000 or real estate sung its swan song in 2008 — but they didn’t.

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Similarly, they should have been scooping up bargains en masse either before, during or not long after markets bottomed in early 2003 and March 2009 — but they didn’t. Greed and fear, which are arguably the greatest determinants of prices over the short-term, are impossible to precisely measure or time. As such, attempting to assess the relative risk of loss versus opportunity cost over shorter horizons is an exercise in futility.

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Valuations are a proxy for the margin of safety

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Valuations serve as a proxy for the margin of safety that is embedded in asset prices, and by extension for how vulnerable prices are to delivering subpar or negative average annualized returns over the next five to seven years.

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Looking at valuations in relation to the state of the economy and profit growth, in a five- to seven-year time frame, valuations on the low end of the historical range in a strong economy with strong profit growth result in well-above average returns. In contrast, valuations on the high end of the historical range in a weak economy with weak profit growth result in well-below average returns.