How should you act in the face of such unpredictability?
First, don’t listen to doomsayers who are convinced financial calamities are imminent. They don’t know. (This is a powerful piece of advice that is seldom adhered to if my recent trip to the AIA Conference is anything to go by)
Second, since avalanches are infrequent, the most logical course of action is to assume the next grain of sand will NOT cause an avalanche. In other words, stop fretting about when the next financial calamity will hit and live a meaningful life.
Third, know that financial calamities will eventually come so be prepared. That means you should scale your exposure to risky assets, such as stocks, to your ability to recover when a market sell-off occurs. Younger investors have a greater ability to withstand market downturns because they have more time to recover from losses, their account balances are smaller and they are continuing to save.
Fourth, while it is impossible to predict when a market downturn will occur, it is possible to know when conditions are ripening for a financial calamity.
Although meteorologists can’t predict if a severe thunderstorm will hit a particular town, they can determine if atmospheric conditions are such that the probability of a severe storm is high.
Examples of financial conditions when market downturns are more likely are when asset categories are expensive, investors are euphoric, debt balances high and the economy is slowing.
Financial calamities can be destructive but there are also positives. They clear out market excesses and provide for excellent investment opportunities for those that have the foresight to be prepared for market corrections, not knowing when they will come but that they eventually will.
More here – J David Stein