New Year’s Resolution #3: Do Not Let an Investment turn into a Trade

There is an old rule — and a good one — for traders:  Do not let a trade turn into an investment.

For individual investors we submit the alternative:  Do not let an investment turn into a trade!

Individual investors tend to look at big declines and bail out of their positions at market bottoms.  They are trying to time the market.  This is a mistake related to time frames, a topic we have carefully covered.

The individual investor is likely to look at a newspaper and think that it provides fresh information, even though the market may have already factored this in.  Individuals also get worried when markets decline, something that is a natural and recurring event, and choose to sell at the worst possible moment.

Acting effectively at these times requires an extensive knowledge of overall factors, market valuation, and overall potential.  Few investors are willing to do the homework required to make these decisions.

It also requires experience, and an understanding of behavioral psychology.  These are times when one’s investment advisor earns his fee.

The Big Mistake

Investors get afraid, and do so at the wrong times.  Here are two interesting perspectives.

A trader on CNBC was commenting on his morning trades today.  That trader was buying the big opening decline (as were we) and wondered who was selling?  "What were they thinking?", he mused.

My RealMoney colleague Scott Rothbert, the finance professor and fund manager at Lakeview Asset Management, has a wonderful educational series for investors at  It is both free and valuable.  An individual investor should set aside time to read the entire series.  Scott wrote at length this morning.  Here was the "money line" for the individual investor:

If you are an investor then invest but don’t switch gears into trading
mode just because of current market emotion. Sticking to your model is
another one of my basic tenets.

This is wise counsel from someone who has been there and knows.

Is it Time to Add to Positions?

Individual investors who have too much of their portfolio in cash, bonds, or real estate, should be asking when to add to equity investments.  This is the one time to think about what traders are doing.

Adam Warner is trading, not buying, and doing it against an options position.  He is not trying to time an entry point, and his viewpoint deserves respect.

Pradeep Bonde discusses the days after 9/11 and the poor advice from talking heads on CNBC.  We remember this and agree with Adam.  The market will find a valuation level that reflects expectations.  The time after 9/11 was not one where investment managers would do "patriotic buying."  Investment managers were trying to figure out what stocks were worth.  They were (sadly, but obviously) worth less than they were before the attacks.  The question now is how much of the current concern is "in the market."  We agree with Pradeep that one cannot know by watching interviews on CNBC.

Brett Steenbarger looks at other panic situations and analyzes subsequent returns.  Dr. Brett is the "go-to guy" on trading psychology.  His conclusion is especially meaningful for the individual investor:

The moral of the story is that, in the short run, panicky markets can
decline further. Investors with longer time horizons, however, have
generally done well by putting money to work when panic fills the air.

Our Take

Our conversations with investors show that many are too heavy in cash and real estate.  The market has offered an opportunity to change the asset allocation at favorable prices.  We are finding many attractive stocks.

The Fed is on the case.  The President and Congress seem to be working toward an agreement.  Since many pundits do not understand how government works, they underestimate the potential.  For many investors it is time to do some buying.

Another wise commentator on CNBC, Vince Farrell, suggested "dollar cost averaging." What he means is that there is an opportunity to take a partial position.  If stocks move lower, buy more.  If stocks move higher, at least the investor can participate.

This is good advice for the nervous investor, something that we have successfully suggested in the past in our discussions of "when to pull the trigger."  It is much better than selling at the bottom.

You may also like


  • Matt January 22, 2008  

    All good advice. Tuesday’s open clearly represented capitulation and panic selling, as seen in the VIX spiking to the high 30s (levels associated with market bottoms in the past). From the complacency of earlier weeks (at much higher prices), investors and traders have now become fearful (despite stocks being much cheaper).
    I think this represents a sea-change of psychology for the market. Any time you see mass-liquidation of stocks, there’s a good chance you are near, if not at, the bottom. With bonds yielding a pittance, now is surely a great time for investors to put on a maximum allocation to equities. I expect from now on, we will see markets opening down (on “bad” news e.g. the Apple earnings), that will fake out weak longs, and then buyers will come in and drive the market to a higher close – in other worse, typical bullish market action.
    Another factor is that stocks are heavily oversold – the S&P is way below the 50 and 200 day moving averages, it is off 20% in 3 months (a very fast move) and it breached the lower Bollinger Band today. Even a move back to the August lows of 1380ish would represent a strong rally from current prices, and a rally to the moving averages (1445-1485) would give a 11-13% return.
    It will be interesting to see how things develop.

  • Mike C January 23, 2008  

    A couple of thoughts:
    In my opinion, regarding asset allocation between say equities, cash, real estate, etc. and adding to equity investments, I really believe it cannot be more strongly emphasized the importance of distinguishing between the broad market (S&P 500) and individual sectors and stocks because the long-term differences can be enormous.
    Since about 1998, the annualized return on the S&P 500 has been absolutely mediocre which includes the 1998-2000 run-up, 2000-2002 drop, and the bull since 2003. One would have been better off in T-bills or bonds.
    In contrast, there are numerous individual stocks and sectors (such as energy and materials stocks) that are multi-baggers many times over during that time frame.
    So the individual investor has to distinguish between buying the broad market versus buying sectors or individual stocks or finding a manager who can do so successfully over time. Whatever the S&P 500 does over the next 5-7 years (which really should be the minimal time frame for an investor committing capital), there will be many stocks that are up 100%+. I think I own a few. 🙂
    “Acting effectively at these times requires an extensive knowledge of overall factors, market valuation, and overall potential. Few investors are willing to do the homework required to make these decisions.”
    In terms of an “investment” versus a “trade” I agree that market valuation must be considered. The difficulty is that there are very, very smart people (you and another PhD former professor) who disagree vehemently on what the proper valuation metric is and who both make a strong persuasive case. I’ve got a MBA in finance from a top 20 school and I can see the validity in both perspectives (which largely boil down to choice of time frame and how much do interest rates matter). How can the average individual investor with little to no training or education in finance possibly determine whether your valuation model and metrics are more valid then Hussman’s? The homework assignment is not an easy one, and there is *ALWAYS* an element of unresolvable uncertainty.
    From a “trade” perspective, and no one really knows for sure, my sense is yesterday was probably a short-term tradable bottom with the combination of the Fed cutting and the market recovering substantially from intra-day lows. However, I suspect this will turn out not to be “THE BOTTOM” and is probably just the bottom of the 1st downleg of a bear market. Traders going long today may have to be nimble on the exit unless they plan on turning their trade into an investment.

  • Jeff Miller January 23, 2008  

    Matt – Market psychology is difficult to predict. I have been highlighting a number of different approaches, including our “Gong Model.” Even after yesterday, the hammer was still being pulled back. We’ll check again tonight.
    For every buyer, there is a seller, of course. I wonder who thinks Apple is a good sale here. …I’m buying back some that I sold at 180, building back to a full position.
    Thanks for your comment.

  • Jeff Miller January 23, 2008  

    Mike –
    The reason I use the S&P 500 is because of the frequent advice to investors that they should just buy index funds. One needs some benchmark.
    I certainly agree that the opportunities in individual stocks are better and more wide-ranging.
    As to Dr. Hussman, he has excellent credentials, what we call good degrees from excellent schools. And you have your finger on what I see as the key flaw in his analysis. To me, it makes absolutely no sense to view stocks the same way when interest rates are 15% as when they are 3.5%.
    Your comment about what the investor needs to do is spot on. There is always some thinking involved, even if only choosing whom to trust.

  • VennData January 23, 2008  

    Isn’t the major difference between you and Dr. Hussman mainly that earnings will (or won’t) revert? Interest rates are very difiificult to predict, but earnings have a bit more persistence, no? Even if it’s just a bit more predictibility?
    And, in fact short term – two weeks – he actually seems a bit more bullish as he describes ‘cleansing rallies.’
    However, of course, you accept and discuss feeback.

  • Jeff Miller January 23, 2008  

    Venn –
    I am glad you asked this question. I do not think that I have ever suggested that corporate profits would not have a mean-reverting tendency. In fact, that is a crucial question.
    I do believe that looking forward is better than looking backwards. I also believe that having hundreds of analysts helping to discover corporate prospects is helpful. As I read their reports, I see many signs that they build in skepticism. I have also written about historical episodes of declines in forward earnings.
    So it is not simply mean reversion.
    As to interest rates, the question is not where they will go but where they are now. The investor, at this moment, has a choice. Buying bonds involves the risk of loss if interest rates move higher. This simple fact is often ignored.
    The appropriate comparison is not between stocks and where we think bonds SHOULD be trading, but where they are trading now.
    The difference in yield is one of skepticism about expected future earnings.
    Your question is excellent, and I hope my answer clarifies things a bit. As I learn how to write better about these subjects, my readers, like you, always show me my errors.

  • Mike C January 24, 2008  

    “Your comment about what the investor needs to do is spot on. There is always some thinking involved, even if only choosing whom to trust.”
    Thanks for the response. I don’t think it is a question of who to trust necessarily. Obviously, I don’t know either you or Dr. Hussman personally, but you both strike me as genuine, decent guys trying to provide investors with information and analysis you truly believe in. Contrary to what some espouse, I don’t think Hussman has an agenda driven my marketing or AUM gathering purposes. Cynics can choose to believe otherwise.
    You and he have different models. David Merkel from Aleph Blog has a different model where if I recall he compares stock yields to corporate bond yields.
    I don’t want to rehash the model debate as it has been done to death. I’ll simply point out the basic Fed model of comparing stock earnings yields to interest rates doesn’t work at all from the mid 1940s to the mid 1960s. P/E ratios were consistently very low relative to bond yields even lower then today. One answer is to say well that time frame isn’t relevant to 2008, only 1970 or 1980 to present matters.
    “I do believe that looking forward is better than looking backwards.”
    On one level, I agree. Yet at the same time, if you read Benjamin Graham’s The Intelligent Investor he was an advocate of looking at average earnings over a 10-year time frame to get a sufficient “margin of safety”. Robert Shiller who is a PhD as well, and a professor at Yale I believe is also an advocate of backwards looking valuation measures. These are not dumb people taking an opposing view.
    My main point is there are very complex questions/issues here with credible, highly-credentialed individuals on both sides. It isn’t enough for the individual investor to “do his homework”. The average 6th grader isn’t going to be able to do integration and solve differential equations.
    Ultimately, some subjective decision making is involved that has trade-offs between opportunity costs and profits missed versus what is an acceptable margin of safety to avoid potentially temporary albeit substantial capital losses.

  • Mike C January 24, 2008  

    “I do believe that looking forward is better than looking backwards. I also believe that having hundreds of analysts helping to discover corporate prospects is helpful. As I read their reports, I see many signs that they build in skepticism. I have also written about historical episodes of declines in forward earnings.”
    I do want to say though that I disagree here. If one relies on forward earnings projections, I’d say you really have to do your own work and come up with your own forecasts. The record of sell-side analysts on forward earnings forecasts really is dismal. The problem is they tend to underreact in both directions. When things are going really good, their estimates are too low, and when things turn they are too slow to cut estimates. Their incentive is to not stray too far from the group and end up looking stupid versus really trying to nail the most accurate forward-looking analysis.
    How many analysts had accurate forward projections for homebuilders for 07 and 08 back in 2005? IIRC, as early as 6 to 12 months ago, I remember seeing estimates for 30% EPS growth in the consumer discretionary sector. LOL. And the problem for the investor is that the stocks start to move either upward or downward WELL BEFORE the analysts change their estimates.
    Take a stock like Apple. For most of the past couple years, estimates have consistently been too low. The stock was in fact cheaper based on the actual earnings that were coming. Now I don’t follow Apple closely so I don’t know the story, but if forward growth is turning down, the analysts will be slow on the downside as well.
    Bottom line, you’ve got to do your own forward analysis and not rely on the analyst community estimates.

  • Mike C January 24, 2008  

    “Venn –
    I am glad you asked this question. *****I do not think that I have ever suggested that corporate profits would not have a mean-reverting tendency.***** In fact, that is a crucial question.”
    OK, final comment and then I have to get to productive work. Jeff, you’ve got a great blog here, and as I’ve said I consistently read it to challenge my own views. I don’t want to seem like I am playing a game of “Gotcha!”, but I think you’ve got to stay consistent with things you’ve said in the past, or acknowledge you’ve changed your mind or altered your view. There are far too many people in the blogosphere who make statements and then seem to conveniently forget what they said a few years back.
    You’ve posted about “earnings mean reversion” in the past with a large degree of skepticism. You may very well be correct, but IMO you can’t forget what you’ve said previously.
    “There are also plenty of miscellaneous arguments lacking evidence. Our favorite radio commentators on Car Talk have a term for such claims concerning car repairs. They call them “BOGUSSSSS”. We will try to identify and discuss several instances including the following:
    “Peak” earnings
    Ignoring interest rates
    The market record of umpteen up days and the need for balance
    Stock buybacks as “inferior” earnings
    Poor recession forecasting
    ***Earnings mean reversion***”
    The clear implication to the reader is that earnings mean reversion is a bogus concept. Maybe it is bogus, but the statement was made.
    “Mean reversion in earnings deserves a full post. ****For now let us just note that one could have been singing that song for several years now.****”
    Sure seems to me like skepticism about mean reversion in earnings.
    I hope you don’t take this the wrong way, but maintaining credibility has to tie in with not making statements that contradict past statements without some acknowledgement of a change in view.