I’m a sucker for market truisms … especially during challenging times. I keep a mess of sticky notes on my desk with favorite sayings that I’ve come across in books, periodicals and online. I like to add one every now and then, though the handful I have are hard to displace.
So I thought I’d keep this article brief and educational by reviewing my favorite market truisms … and how they apply to the current environment.
Only egotists and fools try to pick tops and bottoms. Which one are you?
This one is from the book Hedgehogging by the late Barton Biggs, one of my favorite books. And this market truism is clearly simple—a trend, once in effect, can often last far longer than most investors expect. Yet most investors feel the call of the countertrend, i.e., they’re eager to get out of stocks that are still in uptrends, and conversely, eager to pick bottoms, buying “cheap” stocks that must be “oversold.” In the long run, these methods lead to plenty of pain and missed opportunities.
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It’s hardest to keep things simplest (or simplicity is the ultimate sophistication).
This market truism came from a book called The Perfect Speculator, which is a fictional account of a teaching episode from a market master to an average investor.
Over the years, I’ve tested at least two dozen different market-timing systems, some based on price, some on moving averages, some on sentiment. And as I progressed, I started to get into the arcane (one system, which actually worked decently, measured the rate of change of sentiment, if you can believe it).
I was searching for some sort of Holy Grail, but while I got some good tidbits, nothing I developed was really as effective as trend-following—using a couple of simple moving averages (25-day and 50-day) to tell us the intermediate-term trend of the market. This remains one of my key indicators to this day.
It’s the same for stock selection and finding entry and exit points. In the market, it’s almost always better to keep it simple with some basic, rubber-meets-the-road criteria, instead of delving into the complicated and arcane.
Moreover, you might have a simple, precise plan (say, to hold the stock as long as it trades above its 50-day moving average), but it’s all too easy to be tempted out of that stock because it gets temporarily extended to the upside, or because it has a bad day, or suffers from a bad earnings report, etc.
In today’s market, it’s a similar story: it’s too easy to get overly bullish or bearish depending on the market’s action of the past few days, and it’s very easy to get scared out (or tempted to buy) a stock that really hasn’t done anything noteworthy. When the market “feels” like it’s near a top or bottom, it’s best to put in some buy/sell levels for individual stocks … and then follow the plan!
In theory, theory and practice are the same … but in practice, they are not.
This market truism is actually a quote that applies to nearly everything (not just the stock market) and has been attributed to many people (including Albert Einstein). But in terms of stocks, it applies in a couple of different ways.
The first way is when an investor (often a beginner) figures out that paper trading and actual trading are two different things. It sounds pretty easy to say, “OK, we’re going to buy $10,000 of this stock if it pulls back to 55, place a stop at 50, and then be patient if it goes higher.” It’s another thing to buy it at 55, see it sink to 52 the next day after a downgrade, and see your other stocks sink at the same time because the market is down 250 points … and still hold on because it hasn’t tripped your stop.
The second way I’ve seen this market truism apply to investing (especially in recent months) is that many investors will observe a method working a few times, develop a theory and then put it into practice. For example, an investor holds his three stocks through earnings, and they fall 10% each. So the theory, of course, becomes that you should sell ahead of earnings! But then what happens in practice? The next two stocks gap up 15% and the investor is wondering what’s going on.
Forming theories based on insufficient evidence is one of the most common missteps of investors, in fact, just because something worked two or three times doesn’t mean it will work again. The moral of the story is that forming a system based only on theories, and not experience, can often lead you astray in the market.
The human mind emphasizes being right, not maximizing profits.
This market truism came from the interview with Richard Dennis in The New Market Wizard, one of the best interviews I’ve ever read. In it, Dennis talks about how, as a matter of business, the market “seems” to teach investors to do all the wrong things by tempting us with high-percentage trading strategies.
For instance, a great percentage of the time, a stock that rallies a few days in a row will tend to pull back afterwards. And the opposite is also true; a stock that falls sharply is usually temporarily oversold, leading to a bounce. On a “batting average” basis, then, you’d be better off buying dips and selling rallies.
However, the market is a bad teacher in that sense. If you consistently buy oversold and sell overbought stocks, you might do well for a while, but eventually, you’ll get your head handed to you, because the market is all about outliers, the big gains or big losses in your account. And by constantly betting against the trend, you’ll eventually (and frequently) be caught on the wrong side of some mega-trends. In the long run, betting against a stock’s (or market’s) trend will at the very least leave you disappointed, if not lead to outright losses.
Instead of focusing on being right (a high batting average), a growth investor should focus on the size of his average winner compared to the size of his average loser (which I call the trader’s slugging percentage). Just one or two big winners (i.e., outliers) can make up for a slew of small, almost meaningless losses, and if you capture a few tigers by the tail, your portfolio’s returns will amaze you!
Losers average losers.
Made famous by legendary trader Paul Tudor Jones, my last market truism is a bit of a corollary to the previous one. For a growth investor, the number one, never-break rule is to cut all losses short. Instead, most investors love to average down, buying more of their losers to lower their average cost.
In the book, How to Trade in Stocks, Jesse Livermore gave a great example of a stock trader buying more shares every three points on the way down, detailing how the averaging-down investor thinks. After describing buying more and more from 50 down to 29, the last line was prescient: “Of course abnormal moves such as the one indicated do not happen often. But it is just such abnormal moves against which the speculator must guard to avoid disaster.”
In other words, it’s similar to what I wrote above: averaging down here and there might allow you to “get out even” … but it takes just one severe break in a stock in which you’ve been averaging down to put your portfolio behind the 8 ball.
What market truisms do you live by?
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*This post is periodically updated to reflect market conditions.
