I am crediting this post to Benoit Mandelbrot, who illustrated the 2 irregularities of the financial market as Noah effect and Joseph effect. All quotes in this post are taken from his book, “The (Mis)behaviour of Markets”.
Both of them are biblical characters. Probably Noah is the more famous of the two.
“As Genesis relates, in Noah’s six hundredth year God ordered the Great Flood to purify a wicked world. Then “were all the fountains of the great deep broken up, and the windows of heaven were opened.” Noah survived, of course: He prepared against the coming flood by building a ship strong enough to withstand it. The flood came and went – catastrophic, but transient. Market crashes are like that.” Noah effect is used to indicate that the market crashes from time to time. The effect of each financial crisis is detrimental, with billions of wealth wiped out, but it only lasts for a short period of time.
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And about Joseph: “Pharaoh dreamed that seven fat cattle were feeding in the meadows, when seven lean kine rose out of the Nile and ate them. Likewise, seven scraggly ears of corn consumed seven plump ears. Joseph, a Hebrew slave, called the dreams prophetic: Seven years of famine would follow seven years of prosperity.” To illustrate further, “a big 3 percent change in IBM’s stock one day might precede a 2 percent jump another day, then a 1.5 percent change, then a 3.5 percent move – as if the first big jumps were continuing to echo down the suceeding days’ trading.” What he is trying to say is that market trends. Price moves have momentum, it continues in one direction for a period of time before changing direction. And this is called the Joseph effect. You may be interested to read this post on The Joseph Cycle.
So with the knowledge of these 2 effects, how will it affect how you invest?
First, market will crash whether you like it or not. Buy and hold may not be a good method. Holding on during a crash may deplete your profits greatly. Profit taking when the market is experiencing euphoria may be a more sensible way. This is very important. Avoiding a crash will preserve your capital. However, you can never be able to sell at the market top so you have to make do with exiting early. For traders, a crash is good for shorting. Market come down faster than it goes up, so you earn big profits in a short time when you short during a crisis.
Second, market trends in clusters. This is good news for trend following traders who trade on momentum, getting in the trend and exiting after it ends. Investors can only make money when you hold through at least few of these trends. Even a few of these trends take a few years, that’s why you must have the patience to hold. But once the trends become parabolic, signalling euphoria, you need to exit before the Noah effect kicks in.