The Benefits of Holding Core Positions

My comments in the Community Forum on August 26, 2010

Stock thoughts: Good morning, Team.  The broader market is generally firm this morning, with materials, metals, industrials, oil/gas producers (not an inclusive list) up.  Those are generally “early cycle” stocks.  Those are the stocks/sectors that go up when the market anticipates a strengthening economic recovery.  BUY, BUY, BUY!  Right?  Um, I don’t think so. 

Many of these sectors were deeply oversold.  Remember the “bullish engulfing patterns” that I was describing last night, as well as the general observations about an oversold bounce.  I believe that the “rubber band” effect is driving these stocks.  The jobs number this morning was better than expected, but it’s just a single data point.  To extrapolate further makes you an economist.  Good luck with that snipe hunt.

Over the past couple of days I’ve seen many comments about my notion of “staying involved” in the market rather than just going to cash when you’re fearful, and then piling in when you are confident.  I’m happy that the lights are coming on for many of you.

Here are a few thoughts about staying involved…if only at a very minimal level:

1.  What makes you fearful?  Rapid declines in stock prices.  Think about it — you know I’m right.  You don’t get fearful when the market has moved up a lot.  You become afraid when stocks have declined!  Why?  Because you just lost a bunch of money and you’re afraid that you’ll lose more…or all!  So you go to cash when you are afraid.  So “fear” makes you go to cash.  Or, put another way, when stocks have gone down a bunch, you sell. 

Well that doesn’t make much sense, does it?

2.  What makes you confident?  Rising stock prices.  Lots of buying interest pushes prices higher and as your portfolio increases in value, you feel smarter, more competent, and more confident.  You decide that this trading thing is for you.  You’re a trader!  You might even start buying stocks that are really expensive…because heck, they might even get more expensive.  So you buy, and buy, and buy.

3.  Then, the market turns…as it must.  Why?  Because a buyer, once having bought, is a potential negative force on a stock.  All the cheering in the world isn’t gonna push a stock up even one tick.  It takes demand of new buyers.  And if you’ve already bought, you aren’t a new buyer…you are a potential seller.  (I go into this quite a bit in the Technical Analysis for Non-Technicians download). Once all who wanted to buy have actually bought…we’ve got a bunch of potential sellers.  And potential sellers don’t make stocks go up, they ultimately push them lower.

So you’ve bought all the way up, and now the market turns.  But a common characteristic of traders is that they do not shift bias on a dime.  They stay bullish even as the market comes in.  Why?  Because they have been making money and gaining confidence.  So you “wish” that you had sold right at the top, but your stocks are pulling back a bit.  You say, “That’s OK.  I’ll just sell them when they get back to their peak.” (you know, the one that you now wish you’d sold at when your trades were REALLY profitable!).

But the stocks don’t go back up there.  They fall short of the prior high…and then make a new low.  You’re still profitable, but really wishing you had taken some profits.  Soon, your stocks are underwater and you’d like to at least sell to break even.  You’re concerned and feeling kind of dumb.  Your stocks ebb and flow, gradually drifting lower.  You look at the weekly chart and realize that many of them were actually in weekly volatility squeezes and are now trickling out the bottom of the Bollinger Bands like molasses dripping out of a hose…slowly dribbling downward. 

So you decide that you’ll liquidate your stock…on the next rally.  But that rally doesn’t come.  Instead, the stocks fall so far that you become fearful.  What do you then?  See #1 above.

4.  This entire fiasco is easily avoided.  (By the way, I didn’t learn the 1-3 sequence — I invented it in my trading years ago.  I was on the cutting edge of buying high and selling low).  This habit of losing is avoided by managing risk rather than timing the market.  Yes, the market can be “timed” to the extent that you can spot highs and lows in buying/selling extremes.  But acting on that timing is another thing.  Do you really have the confidence (and competence) to pile in at the right time, or the confidence to liquidate everything at the right time?  The foolish say, “Sure I do”.  But the experienced and prudent say, “Nope.  That’s a pipe dream…and I really don’t like pipes that much.”

So how do we avoid it?  Well, we resolve that we will have a minimum amount of money invested in the market at all times. 

What’s that minimum?  Luke, you’ve got to use The Force to find the answer to that question.  I can’t answer it for you. 

For some, it’s 50%.  For others, it’s 5%.  It depends on more things than I can list here.  But if you are comfortable with that amount of money (which should be a percentage of your capital rather than a numerical/dollar value), then it really should not be “painful” when the market is down.  I understand that this is a common feeling — I see it in the posts here.  Don’t feel uncomfortable.  You’re investing…and part of investing is riding through the dips.  But if you’ve got too much of your portfolio involved when the market is weak and choppy (and you consider yourself an active trader), then you are going to do the wrong thing at the wrong time (See #1). 

Don’t do that. 

Just define what your “stay involved” limit is.  Maybe it’s 1%.  I don’t care, but figure it out! If you are “uncomfortable” or in “pain”, don’t give up on the strategy!  Instead, lighten up on your “stay involved” percentage.

Because here is the intangible (but profitable) benefit of “staying involved”.  Experience.  You will find, over time, that having stayed involved during market weakness did not lead to massive losses and a graveyard shift job at Jack In The Box.  You will find that your decision to remain involved in good companies with strong growth prospects ultimately triumphed over a weak market…because the fundamentals ultimately attracted demand.  Once the market psychology had come full circle, more money was exchanged for stock in your strong companies and that additional trading activity (see “volume”), combined with eager demand, pushed the prices higher. 

You’ll come to understand that there are times in the market when psychological factors so dominate the behavior of traders that the market is completely disconnected with fundamentals.  The underlying reason cuts to the very heart of trading.  What does an equity trader do?  An equity trader does one of two things.

1.  Exchange cash for stock. (Buy stock)

2.  Exchange stock for cash.  (Sell stock)

When forces team up to create a “perfect storm” of fear, the desire for the safety of cash becomes so great that traders will sell what they have at any price.  If they had a pocket full of diamonds, they’d sell it for fifty bucks!  They are that scared!

We are all subject to those forces to a certain extent.  The extent to which that stuff impacts us is inversely related to our experience.  Experienced traders understand what is happening.  They have ample cash to exchange for stock when the masses are blindly rushing for the exits holding diamonds in their hands asking for bids.

The only way traders get experience is to start making the right decisions.  A trader who continues to make wrong decisions becomes someone who used to trade.  I’m sure you know some of them.  They are the ones who constantly gripe about the market being rigged; Wall Street is crooked; nobody can make money in stocks; etc.  All that stuff is dumb and a waste of time.  Is the market rigged?  Is Wall Street crooked?  Can anybody make money on stocks? 

Answering in order:

Is the market rigged?  Who cares.  Only losers even ask that question as a means of dismissing their own lack of competence and success.  Winners figure it out; they adapt; they learn the rules and follow the rules.  Look, stocks go up and down.  Pick stocks in good companies.  If the is “rigged”, it is “rigged” in favor of those who hold stocks in good companies.  Owning the best companies will ultimately result in profits.  And if the stock in your “good company” goes down to zero…well, I guess it wasn’t such a good company, was it?  But if you’ve got the right company, then only time frame is an issue. Ultimately, you’re gonna win.

Is Wall Street crooked?  Actually, no.  I’ve been there.  It’s pretty straight and you can stand at one end and see clear down to the other end…if you can see past the hot dog vendors and picture-taking tourists.  For our purposes, “Wall Street” is not a street.  It is an amorphous blob that is made up by the masses.  You and I are Wall Street.  Karen Finerman is Wall Street.  Jim Cramer (and all of his subscribers) is Wall Street.  The guy trading over in the Philippine Islands is Wall Street, as is the guy pushing the buy button on his Blackberry mobile ETrade platform while riding the train to work.

Describing Wall Street as crooked is a description for losers.  Bernie Madoff was one guy.  One pathological guy with Narcissistic Personality Disorder. He doesn’t define Wall Street.  He profited from the laziness and ignorance of others who were lulled by something that was “too good to be true.”  (I’m not disparaging anyone here — “ignorance” is not an insult, it’s a descriptive term that unfortunately described many of his investors — they just didn’t know any better).  If you’re going to use Madoff or other poster children for the inherent greed of man to justify a “Wall  Street is crooked” mindset, you’ll always be a failure.  Always!  Why?  Because every field is full of criminals and crooks.  It’s not limited to the financial markets.  Winners learn to thrive; losers learn to leave…and then go to the next thing which they ultimately leave too.  They become bitter and condescending.  They live in Negative Town — that fictional neighborhood where no one trusts each other and the glass is never even half empty; it is bone dry.

When you hold stocks of good companies through thick and thin, you’ll ultimately succeed.  But the devil is in the details…and the details are what Stock Market Mentor is dedicated to teaching.  Reading the price action and understanding

So figure out what percentage of your portfolio is dedicated to being involved in equities.  If it is too big, you’ll quickly know it.  How?  Because you’ll really feel sick when the market is down big.  You’ll struggle to hold…and you’ll ultimately sell.  (Please let me know when you do, because that will be the bottom that I’d like to buy).  But if your position is the right size (now…a small, minimal size), then you’ll understand that this is not a “once-in-a-lifetime buying opportunity”.  That’s laughable.  You’ll understand that this is a very, very rough patch in the market do to a confluence of forces that rarely crop up. 

So yes, I’ll say it: “This time IS different”.  It absolutely IS different.  I am quite confident in my assessment that “the times, they are a changin’.”

But even though this time IS different…the one truth of investing remains intact.  When you own good companies that are growing, you’ll profit from that ownership.

But you need experience to gain the confidence to hold through the rough patch and come out the other side pristine, bright and happy.

And the best way to gain that experience/confidence is to have a very small involvement in the market, thereby enabling you to feel the emotions that traders feel, but just to a lesser extent.

So stick with the concepts that we have been working on lately.  Define your “core” position size.  Understand the companies that you are holding.  What is their growth profile?  What is their revenue trend?  What does the chart look like?  Are they growing…or just growing old (see MSFT and DELL for two great examples of the latter).

Hope this helps provide some clarity and insight into how your own mind works.

Have a great day.

Dan