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 TheStreet.com. 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 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.