How the Individual Investor Can Trade Like a Pro

It has been well documented that individual investors trail the market averages when it comes to investment performance.  The "buy and hold" concept has little respect these days, but most individual investors do even worse.

There are many reasons for this, but bad market timing heads the list.  As many regular readers know, I have been working on a book aimed at helping individual investors.  Part of my approach is explaining how professionals think about problems.  Here is one example.

The Concept of Upside Risk

There is a concept well known to financial professionals, but rarely considered by the individual investor.  It is the concept of upside risk.  Briefly put, it means you have a position that will be a loser if prices move higher.  Here are a few examples:

  • The most obvious case is the hedge fund manager who is “short” a stock.  This means that his fund profits when the stock goes down and loses when it goes up.  His risk is to the upside.
  • Mutual fund managers try to beat a specific benchmark.  When they are partly out of the market, or in very conservative investments, their risk is to the upside.
  • When a stock analyst writes a professional report recommending a stock, she lists all of the factors that could be problems for the company.  When the analyst recommends against owning a stock, she lists all of the things that might be better than expected.  The risk is to the upside.

This is an indispensible concept for the individual investor.  It starts with analyzing your personal situation

The Key Investor Question:  What is Your Risk?

The average investor thinks only about the downside.  Because of our natural human instincts, well established in the psychological studies of behavioral finance, we all focus on what we might lose.  This can have a paralyzing effect.

Meanwhile, there is a constant barrage of news about problems.  This is the grist for the daily media reports.

Professionals cut through this news.  They have a specific market plan, balancing risk with reward.  Most individual investors do not have a strong plan — one with a specific target and a process to reach the goal.  They often make the mistake of treating their investments like a poker game where they are “all in”  — or all out.

The Acid Test

If you have all the money you need for your future, you should be preserving capital.  I understand that interest rates are low, but security is important.  Be cautious!

Most of us are not in that happy position.  We need to create wealth, not just to preserve wealth.

If you have significant future needs, and you do not own any stocks, you have upside risk.

To appreciate the risk you should ask yourself what will you do if the market goes to 15,000?  To 20,000?  When will you decide to buy?  If you do not have a plan, it means that you will miss out in achieving your goals.

Every portfolio needs a balanced asset allocation.  The right answer is different for each investor.

Key Takeaway

The professional investor views risk in terms of upside and downside.  The amateur looks only at the downside.  He fails to ask decisively when there is opportunity and chases the market at peaks.  There is no better time to invest than when there are many well-known and well-documented worries.  A bad time to invest is when no one is worried.

This is very difficult to understand, and even harder to implement.

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  • Jeff July 13, 2011  

    Very nice article.
    In your ‘key takeaway’ section, your conclusion that: “There is no better time to invest than when there are many well-known and well-documented worries. A bad time to invest is when no one is worried.” reminded me of similar quotations from two legendary investors: (1) “The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell” — John Templeton; and (2) “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful” — Warren Buffett
    In your new book, perhaps you might consider using quotes (such as these) from successful investors to help emphasize your major themes? — Just a suggestion for you to consider.

  • inkerton July 13, 2011  

    Well, as an individual investor who interacts with many other individual investors, I think this article only has it about half-right.
    I think the average individual investor, at any given time, is focused EITHER entirely on the upside, or entirely on the downside. The average individual investor was focused entirely on the upside in 1999, and in 2006/2007. The average individual investor has been focused entirely on the downside since, oh, say around 9/15/2008, and that hasn’t changed very much since then.
    You get at this when you talk about the “all-in” or “all-out” mentality. But the statement “The average investor thinks only about the downside” should have the words, “these days” appended to the end of it.
    Whereas pros, in my conception of ya’ll, are ALWAYS focused on BOTH the upside AND the downside.

  • ninan July 26, 2011  

    It seems one should separate the optimal portfolio from the individual risk. The former is independent of who the investor is. The latter is purely defined by the percentage of cash allocated. The numerous asset allocations for conservative, aggressive etc. investors is a joke perpetrated on retail investors. I thin research establishments should earn their keep by licensing what they think is their optimal portfolio every year and let individual decide how much risk they want to take.