How will stocks react to Hurricane Sandy?

Sandy dropped just below hurricane status before making landfall near Atlantic City, N.J. and left devastation all along the East Coast. CBS News' Jeff Glor reports.

(MoneyWatch) As Hurricane Sandy approached the East Coast on Monday, investors did what they usually do in such cases -- they ran for the safety of Treasury bonds. This despite even Jim Cramer telling investors that making moves based on the storm isn't likely to make you money. Fleeing to safety once a storm is on the way is the kind of reaction that gets investors in trouble: when you get away from your investment plan and make decisions based on the short term.

One of the most important concepts that investors need to understand in order to be successful is that a huge share of stock returns is attributable to surprises -- unforecastable events. This can mean natural disasters such as the 2011 Japanese earthquake, man-made disasters such as the 2006 BP oil spill or simply earnings announcements that don't line up with market expectations. So the first thing you should ask about a hurricane is: Am I the only one who knows about the storm and the potential damage it can do?

If you've been following my blog for a while, you know my feelings on what Jim Cramer does, but I have to give him credit when he gives good advice. When talking about investing in companies such as Home Depot (HD) or Lowe's (LOW) in light of the storm, he said, "those stocks would have moved days ago, long before anyone even knew who Sandy was. The market is, in fact, ready to make money off of those late-comers to the hurricane trade. That's why investing, not trading, makes more sense than ever."

Since the storm has been a highly publicized event, it's obvious the investors are well aware of the impact the storm can have. Therefore, we can safely assume that the expected outcome is already built into prices. So, for example, the prices of the stocks of insurance companies surely already include an estimate of losses. Thus, it's only if the losses are greater than expected that we should expect their stock prices to fall further. On the other hand if the losses are less than expected, their stocks are likely to rise. Again, surprises are what cause the big price moves, and by definition surprises aren't forecastable. (That doesn't seem to stop investors from reacting anyway.)

One of the great things about being a believer in the relatively high efficiency of markets -- and avoiding the mistakes active investors persistently make -- is that it allows you focus on the really important things in your life, such as your family, friends, hobbies, and so on.

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    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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