Sunday, 22 June 2014

A "Crash Course" in Investor Psychology

Investing and trading are two entirely different things. Investing is something you do for the long-term based solely upon fundamental analysis. If you feel there will be a rising demand, for example, you can fundamentally make a mathematical case for a stock to rise - and hope that a black swan doesn't prove you wrong while you wait for possibly three, five, or even ten years until you are proven right.

For example, I was reading the other day that uranium is selling for $28, while it costs $70 to get it out of the ground. Uranium has been dirt cheap for a long while now because of the United States and the USSR deactivating so many of their nuclear weapons after the Cold War ended - it is somewhat of a temporarily manipulated market because of stored up supply being released into the market. Demand for new uranium mines plummeted as a result - I mean, look at the difference in cost above. There has been no money to be made in uranium mining for 20 years, only losses. As a result, there has also been no exploration & prospecting into the uranium mining industry. Further, even if we knew where there were big deposits, it would still take five years to get a mine built and to the point where it was actually producing uranium. The thing is, the uranium supply glut from the nuclear weapons dis-armaments is almost gone - and there are no new mines being built nor even being explored for. There are only a few left-over mines still operating, which often only have a life of only 20 to 30 years before being "mined out." Therefore, a strong case can, and has, been made that the price of uranium must rise over the next decade. It's the simple Law of Supply and Demand. Further sentiment into the industry has soured because of the Fukishima Nuclear Reactor Disaster, causing other countries to pledge to shut down their own nuclear reactors... but this is just psychology - barring a "black swan event," such as the discovery of cold fusion, the fundamentals will win out, eventually. Germany, for example, has shut down some of their reactors, but now is producing more pollution by burning coal - and that doesn't even replace the energy loss completely, so they are now buying nuclear energy from France to meet the demand. Hmmm... and now, with the troubles in the Ukraine, the members of NATO are going to engage in an insane trade-war with Russia, causing Putin to threaten to turn off the 40% of the natural gas which is supplied to Europe from Russia? How long does anyone really think it will take for people to be paying $1,500/month to heat their homes before the Nuclear Reactors get fired up again?

That is investing.

Rationally, there is a strong case to be made for putting a portion of your portfolio into uranium stocks. There is still risk, because you can never be certain of the future, but fundamentally, the price of uranium should rise over the next decade and some companies which are today only mildly profitable might soon become wildly profitable. Buying a "basket" of uranium stocks and intending on holding them for the long term is probably a smart thing to do... Remember to do your own due diligence though, and research it for yourself. You must do this, not only for me stating it for legal purposes, but also because it is through your due diligence that you will begin to see opportunities like this. Your research is essential to being an investor. How else can you find the fundamentals to rationally make your case to buy, hold, or sell? And you don't have to be right all the time when you are an investor. So, with diversifying your investments and having a strict, non-emotional strategy to buy or sell them, you can again make the case that you only have to be right 51% of the time in order to become a millionaire - given enough time. The more you research and look for opportunities, the more times you will pick the right investments, and the faster you will reach your goals.

Trading, however, is different than investing. It is based far more on psychology - more specifically, short term psychology, and often can ignore the fundamentals that make up investing. I see lots of professional "investment managers" turn a snooty nose to "traders" who are "gambling." In a way, they are right - trying to make money as the middle man with a quick trade that's not necessarily based upon fundamentals but a guess purely of the future whims of the market, kinda does seem like the "shady used-car salesman" way to make money. He doesn't really care if it's a Ford, Chev, Toyota or Ferrari - he loves them all, and for the right price this particular one is the best car in the world - today. Therefore, his views on "the best car" are highly suspect. Same as a trader. He doesn't care if there's a fundamental case for Apple to be valued at $300 or $700. He just wants to catch the ride somewhere in the middle to make a quick buck - a trade.

But on the other hand, there are also real fundamental elements to trading. It can be kinda like counting cards while playing blackjack in the Casino. The more you are aware of the nature of the deck, and what the odds are of the remaining cards being this way or that way, means you can significantly improve you chances of winning. I'm not talking about day trading here - although I do occasionally engage in that. I've tried day trading before and it is far too much of a gamble to be a reliable strategy. About the only day-trades I'll do anymore is if I luck into buying something I was intending to keep for longer, but it goes up maybe five percent by the end of the day or by the next. Far more what I have done is swing trading - and I always couple it with my investing strategy, which I have outlined above. I don't just pick any old stock - I find a stock I want to own anyway, in a sector I believe has fundamental reasons to be invested in, so that if I do trade into it wrong it's at least something I was willing to hold for a while anyway. You cannot force the market to behave the way you want it to - you work on its schedule, not your own. Patience is the key to trading. You can only watch to see when you can take advantage of some particular event or phenomenon. If you see an opportunity, you take it. If you don't see one, you do nothing - you can't force something to happen on your schedule. That is key to understanding how to be successful or unsuccessful. Day-trading is far too much about driving yourself nuts trying to guess what the market will do today. It's the anti-thesis of patience.

Swing Trading is more about observing market sentiment by using "technical analysis." No market goes straight up every day forever. It moves up or down according to a trend, or a pattern. A stock trades in a channel from, say, $10.00 to $11.00, then pulls back to $10.50, and then rises to $11.50, pulling back again to $11.00 before rising to $12.00. Therefore, there is a "trading channel" of a dollar, or an 8-10% swing that bounces back and forth while the general trend of the stock is still rising overall. There is quite a bit of "extra money" that can be made by trading in a channel like this every couple of weeks. A $10,000 position might be able to not only rise 20% to $12,000 over, say, six months, but you also have the opportunity to trade in and out of it at least three times while still catching "the overall uptrend" - perhaps to the profit of $500 per trade if you properly buy and sell between the bottoms and tops of the channel, not trying to maximize the gap, but just making sure you participate in it, by $0.50 per each $1.00 bounce as in my example. Thus, what was a 20% rise in value if left alone, now becomes a profit of 35% through properly trading it.

There are other technical-chart analysis tools you can reliably use to maximize profits, such as 50 and 200-day "moving averages." Obviously these averages just smooth out the "bumps" of the channel described above, but sometimes they give very clear signals of the psychology of the market. When the 50 day moving average crosses above the 200 day moving average, it is called a "Golden Cross," and no matter the actual fundamentals of the company, it clearly indicates that money is moving into the stock fast, and the momentum behind this will cause the price to rise over the next while. Buying into a Golden Cross is a fairly reliable way to do a quick trade, because the odds of that momentum of money causing the stock to rise are high. It is based purely on psychology, without fundamentals mattering, yet there is a fundamental and mathematical reason to buy into it.

Conversely, when the 50 day moves below the 200 day, it is called a "Death Cross," because it indicates market psychology is fast trending towards leaving that stock, causing the price to fall. There are fundamental reasons - based on supply and demand - to sell that stock/commodity rather than to hold it. 

What I tend to do is I buy my stocks with an investment strategy and then I always try to trade a few of those stocks around to make a few extra bucks of income while I'm waiting. A decently diversified portfolio should have around 20 stocks - each "full position" ought to be around 5% of your portfolio. You should have no more than 20% of your portfolio in any one sector, meaning that if you buy full positions in Apple, Google, Blackberry and Facebook, your "tech sector" is now fully 20% of your portfolio and you can't buy another stock in that sector without selling one of the stocks you already own first. (You can see why it was so bad for me to break this rule with what happened to me in the gold mining sector - Stupid. Stupid. Stupid.).

This type of investment strategy works beautifully for generating some extra income from trading, because out of five different sectors, each with four different stocks, there is usually something that is in the profit and available to be played with. Maybe the mining sector sucks right now, but tech is doing great - so you trade around with a tech stock and leave everything else alone. If the trading gets away on you - for example, I buy my one stock at $10.00, sell it at $10.75 and wait for it to drop back to $10.25... and wait... and watch it instead rise to $11.75, I just take my $750 profit and never look at that stock again - I'll find a new stock in that sector to replace it with. Often times, even with my long-term investments, when I decide to sell them, I will play with trading them as long as I can until the market takes it out of my reach. I was going to sell it anyways, why not try to make an extra thousand or two for pin money along the way. This trading strategy that you "let get away from you" also has the effect of making you take profits on your stocks as they rise. You should always be taking some profits and raising cash when they make a considerable move upwards anyways - nobody ever went broke making a profit, but they do go broke by not taking profits when they are available to be taken. If you hold Google all the way from $500 to $1200, then watch it drop all the way back down to $400, you never actually made any money at all - even though you might have been telling yourself you had because you figured out your "profit" on a calculator each day. Profits sit in the bank and look like hard currency.      

But alas, I have been creamed in the markets over the past two years because I broke my rules and was severely over-invested in one sector, then further broke my rules by over-riding my stop-loss discipline. So take what I have to say with a grain of salt. I am putting my failures up here to show what not to do, as well as putting up my successes to show what I've found actually works.     

I have to return to my trading disciplines which I've shown myself can work, but I also think I'm going to try to do something a bit different in the future. The opportunities during a "market crash" are enormous. The best investment I've ever made was during the Credit Crisis of '08/09. I could have done better - much better. I still had some capital but didn't put it to good enough use when I could have. For example, the Canadian banking sector got just creamed during the crisis. These were "blue-chip for grannies and orphans" kind of stocks that generally paid a nice dividend of around 3%/yr, and the banks generally raise the dividends once or twice a year, and have for decades - some for over a century. One bank - the Bank of Montreal, lost 60% of its market-cap during the crisis because they were over-exposed to US debt, and all five Canadian banks got smoked in the stock market because of it. RBC, Scotiabank, CIBC, TD etc., all were more than halved in value and their yields from dividends rose into the 8-9% range. The Bank of Montreal's was paying 11% when it's stock dropped into the $25 range. I was telling myself... buy into them... buy into them... you really should... ALL of these banks aren't going to go broke, I doubt even the Bank of Montreal is going to go broke. I chickened out and didn't buy them. A year or two later, they had all doubled or more in price - plus they paid one heck of a good return through dividends while doing so. It was an opportunity lost.

I once read an article, I forget by who, that had the best description of "buying a crash" I have ever read: Think of a large crowd - 100 people perhaps in a street setting, just before a big riot is going to start. Someone picks up a rock and lobs it towards the crowd... and what happens? The entire crowd of a hundred of people will duck as they see the incoming rock. There is no way that one rock can hit any more than one of them - statistically, you have a 99% chance of not being hit by the rock. The key to buying into a crash therefore, is the same as being in that crowd, but forcing yourself not to duck. Those that can do this will be able to run around picking up stocks at bargain basement prices because they are the only ones around to take advantage of the opportunities.  

It is apparent to me that an effective trading strategy is also one that constantly raises capital to take advantage of the inevitable crash, which on average occur once every five and a half years. Only rarely in the past century have we gone longer than seven years without a crash. Crashes are regular occurrences and you should always be prepared for them because you can make more money buying into a crash that blindly drags down quality companies, than you can from successfully investing in those same companies during stable times.

As an individual investor, you don't have to be like all those fancy shmancy investment managers on TV. They often have mandates to be fully invested in the markets - which is why they are always talking about "beating the market" even in a down year. Yeah, sure... the markets went down 20% this year, but you "only" went down 15%. See? I beat the market by 5%. Success! They do it this way because most of them don't actually get paid by performance, but by an MER of perhaps 2-3% - a commission they get paid on the full amount of their multi-million (or billion) dollar portfolio which they manage. They will make more money by safely parking it in the market - beating it by only a few percent - and then trying to convince more people to give them money to invest, than they will make by being effective investors. If you get paid a 2.5% MER on a million dollars, it comes to $25,000/yr. Sure these guys are still overall trying to make money, but they often do much better by convincing ten more people to give them another million to invest with, than trying to double the initial million. $2 million means $50,000/yr, and it doesn't really matter to them if the stocks go up or down overall. If that $2 million drops to $1.7 million, they still collect their MER of 2.5% on the $1.7 million... sell another three people on giving him $100,000 each, and he's still making $50,000/yr even though he's lost money for all of his clients. I very much dislike that system, and it also makes me suspect of some professional investors' advice - just like car salesmen will never honestly tell you that you ought to quit driving altogether and buy a bike. It's against his interests to do so, even if it's in yours.

There are bigger "channels" in the general market than just the "swing" of a stock as it bounces around in the short term. These big channels - which include market corrections and even the crashes - are never taken fully advantage of by professional investors who are always mandated to be fully invested... but you, as an individual, don't have any such mandate.

Right at the moment we are about five and a half years since the bottom of the last crash - we are exactly at the "average" length of time for another one to occur. If you don't have cash to take advantage of the opportunities found within the carnage that is likely to come sometime soon, you will only have the pain and none of the glory. As an individual, there is nothing wrong with being only 70% invested at all times, so you have dry powder to take advantage of the opportunities, and sometimes - like right now - being perhaps only 30% invested with a huge amount of cash waiting on the sidelines is the best move.         

The crash is not only where all the money gets lost... it's also where all the money gets made - for those who are disciplined enough to prepare for it. In fact, there is a strong case to be made that the opportunities in a crash are so great, that one should only invest during a crash, then start selling out a few years later and sitting on 100% cash until the markets demolish themselves again in their inevitable boom-bust cycle which has been a regularly occurring trend for centuries already.
Related Articles:
What I Learned Managing My Own Investment Portfolio
It's All About Getting Out, Not In -- by Mark St. Cyr

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