At any given point, an investor faces the decision to buy, sell or hold an investment. When those decisions are isolated, without any reference of price or time, then they can be viewed as having an identical expected value (EV) over the long term. In other words, they can be viewed as being random in nature.
It is only when referenced against time, price, performance, history and other variables that dictate an investor's behavior that the long-term EV of each decision will cause the necessary edge to outperform or in a negative scenario, the undesirable disadvantage of underperformance.
The long-term EV of adding, reducing or remaining steady in exposure is up to each investor to determine. There is no black and white definition of what adds EV because each investors method of investment, psychology and decision making process varies. There is one standard, however, that should be at the forefront of an investor's mind with each decision: Is the long-term expected value of this decision positive?
That means that each decision you make is made against a framework of 100, 500 or 1000 similar decisions that are made during an investor's tenure as market participant. If the decision has a negative EV over the long-term then it doesn't matter if you feel you will be successful this one time. What is important is that you know that your nature, framework, psychology or whatever you decide to classify it as is such that over a period of time, the decision will prove harmful.
Let's look at EV as it applies to everyday life: Today I walked by a fancy jewelry store that had lots of glistening diamonds, intricate watches and ornate bracelets in the window. Let's assume that instead of walking by I decided to pull my shirt over my face and proceeded to rob that jewelry store. Let's also assume that I was somewhat savvy in my approach, pulling off this robbery with minimal detection and therefore, no obvious consequences.
The long-term EV of this approach to the jewelry store is multi-faceted. First, given the short-term satisfaction and ease with which I was able to "come up," my perception of jewelry stores would change. This change in perception from a jewelry store being somewhere you shop at to a profit center with infinite returns would permanently shift every other decision I make that has a positive EV. The relative returns of these positive EV decisions simply wouldn't carry weight versus the infinite returns of the jewelry store.
It would then become inevitable that I repeat the decision with the negative long-term EV, which is to not simply walk past another jewelry store, but rather use it as a profit center with infinite returns. Of course, the negative aspects of this decision would eventually come to light as I would either get shot by an angry store owner that sees me as a detriment to his long-term EV or arrested by police that see me as a detriment to the long-term EV of society.
The same lack of thinking about the long-term EV of a decision in the markets can lead to a slippery slope of decisions that eventually turn a stock investor into an investor in CDs.
Decision making as it applies to finance should not be isolated, but rather thought of against a broad range of similar decisions to examine the long-term EV such a decision carries.
