Posts filed under “Apprenticed Investor”
I love this quote:
“Overestimation occurs, in part, because people who are unskilled in these domains suffer a dual burden: Not only do these people reach erroneous conclusions and make unfortunate choices, but their incompetence robs them of the metacognitive ability to realize it.”
I have to work that into my presentation today: “unfortunately. their incompetence robs them of the metacognitive ability to realize erroneous conclusions.
This is a reprint from 2003, originally published at MarketWatch:
NEW YORK (CBS.MW) — The Duke of Wellington once observed: “What makes a great general? To know when to retreat; and to dare to do it.”
The same thinking applies to investors. They must understand when to “retreat,” and have the self-discipline to do so. This is especially true in the present environment. The pre-war “spike” last month shows why. Eight straight up days, with gains of more than 13 percent, makes it too easy to become complacent and forget about risk management.
Once the market lurched into rally mode, I’ll bet many investors let their emotions get the better of them. Ask yourself these questions: Did the best week in over 20 years suck you in without a coherent exit strategy? That stupendous run was followed by the single worst day in over a year. Was it only then you discovered that you had no contingency plan?
Perhaps, then, its time you developed a risk management strategy – including a sell discipline.
A Strategy for Every Market
Bulls and bears alike need to preserve capital and manage risk. These tactics are crucial regardless of whether the market is crashing or rallying, whether there’s a war on or the economy is in recession.
Take the present environment. From studying market history, I believe that major crashes (think 1929 and 1972-74) are followed by years of range bound trading. Until I see otherwise, I expect growth to be anemic, deficits to keep increasing, and business spending and hiring to remain weak. There’s still too much capacity, too much debt, and the increasing possibility of deflation. Despite this, stocks are not at historically cheap valuations. On the bright side, interest rates are at 40-year lows, and that makes present equity valuations a bit more sufferable.
These crosscurrents make it all the more imperative to have a reliable plan – before you run into trouble.
Risk management methodologies are designed to help you avoid devastating losses. The stop loss is the most basic tactic in your arsenal. Stops work because they define losses in advance. They provide an investor with an objective set of criteria for selling any position. This allows an investor to exit a holding before becoming emotionally involved.
Whenever I review a portfolio down 50 percent or worse, I know I’m seeing the handiwork of an investor who lacks a sell discipline.
Why are stop losses effective? Simply stated, there’s only so much any stock can do. It can go up a little or down a little. It can go up a lot — and here’s what is so devastating to portfolios — it can also go down a whole lot.
Investors who avoid the last scenario spare themselves the kinds of losses that are difficult to recover from.
Let’s look at some specific stocks to see how individual investors can apply different types of stop loss principals.
This is something that I want to discuss in general terms — I want readers to not only understand my perspective, but to grasp what typically occurs heading into recessions and recoveries, into new bull and bear markets. (Note I am speaking generally, and not referring tot he details of this cycle).
Over the next week, I will put together a broad overview of the positives and negatives of the economy, looking at the risks and opportunities presented. For now, let’s discuss the sentiment that typically accompanies oscillating phenomena, such as markets or the economic cycle.
Today, I want to look at the big overview. Historically, the sentiment that occurs at inflection points are extremes. The are the result of the prior few years of economic/market activity. They lag the cycle — often quite significantly.
• Humans have an unfortunate tendency of to overemphasize our most recent experiences. We draw from what has just happened, rather than deduce based on what is occurring right now.
• Following that idea, the analyst community is typically too bullish at tops, too bearish at bottoms. They extrapolate from the most recent data to infinity or zero. Hence, they miss the inflection points.
• Sentiment is a justification of recent actions. Very often, equity buyers describe themselves as bullish after their purchase. The comments they make can are often an attempt to reassure themselves.
• Changing viewpoints is a gradual process. Flipping from bullish to bearish and vice versa is difficult. We remember what most recently rewarded us, and internalize that. After a period of economic expansion, we are slow to grasp the change for the worse. At the tail end of an ugly recession, we find it hard to imagine an imminent improvement.
• Investors develop the equivalent of Muscle memory. During a bull market, every dip that was bought made us money. When the cycle changes, we are slow to perceive it. Bulls become out of phase with what is taking place, buying on the way down in a bear market.
• The reverse takes place after a long Bear market. Selling rallies made us money, preserved capital during the downturn. When the sell off ends and a new bull cycle begins, the bears have a similar hard time getting back into sync with the market. Since it was so rewarding to sell into prior rallies, it becomes difficult to flip towards the positive perspective.
• Excuse making rationalizing the missed turn becomes endemic. We get conspiracy theories (the Fed is buying SPX minis!), complaints about the artifice of the market, Fed bashing, etc. They all have their roots in the missed turn. I even suspect some of the Goldman bashing (deserved tho it may be) is also partly rooted in this issue.
Consider this chart, which I first showed back in 2005 — but its worth reviewing again:
If you like these sorts of things, there are more psychology visualizations after the jump . . .
This was originally published ~5 years ago, on April 26, 20005 – 07:20 AM at TheStreet.com.
In light of some of the pushback to Friday’s commentary, I thought it might be worthwhile trotting it out again. This is an unedited version of the original, typos and all. The only change was to add the links to the related Apprenticed Investor articles.
I had an entirely different column in mind for today. But the events of last week were so peculiar, and so revealing of another classic investor foible, that I shifted gears.
This will be one of the few Apprenticed Investor columns written in response to current events. I’m doing so because I feel it’s necessary to address last week’s topsy-turvy market action. More specifically, the investor reaction to it.
A brief background: In my day job, I advise institutional investors on the state of the markets. When risk, according to my metrics, has risen unacceptably relative to reward, I become cautious. When the reverse happens, I get more aggressive. This has been my style for some time, and it works for me. Once I explain the process, I’ll lay out the mistakes the public makes in reaction to these market calls.
‘Are You a Bull or a Bear?’
I’ve heard this question countless times the past few weeks. And I find it a stunning rejection of Darwinian logic that proponents of such blather have managed to evade extinction. Investors simply never get asked a more distracting and pointless question. Effective investors find their style, then read the market and adapt accordingly.
Of course, in discussions about Wall Street, the bull and bear are mesmerizing. How often do we hear a newscaster somberly intoning: “The bears got gored by the bulls on Wall Street today…” The very next day, we hear the same talking head reverse course: “On Wall Street, the bears came out of their caves to chase the bulls, as the Dow dropped…”
The markets we saw last Wednesday and Thursday are textbook examples of why the colorful imagery of the bulls and bears is magnetically attractive to copywriters and repellent to good investing.
Why is this such a problem? Because of the “folly of forecasting“: Once people commit to a position, there is an unfortunate tendency to root for that perspective. Even worse, people stick with their forecast, regardless of what is actually happening in the market. We addressed this in the very first Apprenticed Investor, Expect to be Wrong. But instead of preparing, people dig their heels in and cost themselves money by being more concerned with trying to be right rather than making money.
Surely, there are cheaper places to look for validation than the stock market.
Bull and Bear, a Matched Pair
In a firm I worked at during the bubble years, many of the brokers had bulls on their desks, but no bears. I used to take away their bulls, and refuse to return them unless they promised to display the bear also. I did this to prove a point: There are two sides to every market.
This morning’s post discussing Floyd Norris front page NYT column generated even more pushback than I expected. I am always trying to create rules to help make better investment decisions and fight against my own wetware. The earlier comment stream led me to these ten ideas; ignore them at your own risk: • Whether a…Read More
Funny how these things work: In a rant Friday morning, I wrote: “Regular readers know that I despise political parties, believe partisans suffer brain damage — literally, they have the same cognitive deficits that ardent sports fans suffer. I have trashed both Bush and Obama, but moved to a bullish posture when despite either’s incompetence,…Read More
While I am not a fan of most big firm fundamental analysts, over the years, Merrill Lynch has had some sharp guys in their Chief Strategist/Economist positions. Here are some lessons and rules from 3 of them. Richard Bernstein was “notoriously cautious on stocks for much of this decade” — and was very bearish on…Read More
With 2010 underway, its important to look back at the year gone by to assess — what was done correctly can take care of its self, but the areas that need improvement require active intervention. All told, 2009 was a year rife with both risk and opportunity. If you avoided the risk and took advantage…Read More
When he was at Societe Generale, I very much enjoyed the work of James Montier. He is now working with Jeremy Grantham at GMO. I have two of James’ books in my queue, Behavioural Finance: Insights into Irrational Minds and Markets (2002) and Behavioural Investing: A Practitioners Guide to Applying Behavioural Finance (2007). He hasn’t…Read More
Here are the full run of reviews of the book:
Mainstream Media Reviews
New York Times:
Rescues Unlimited: Government as Wall Street’s Enabler
By DEVIN LEONARD
NYT, August 2, 2009
Wall Street Journal:
… And Dave Has His Book List
WSJ, July 26, 2009
Greenspan Flunks Test, Bush Falls Into $15 Trillion Pit: Books
Review by James Pressley
Bloomberg, May 27 2009
Book Review: Rescue Fatigue
Michael Maiello, 07.16.09, 12:01 AM EDT
Barry Ritholtz’s ”Bailout Nation.”
Named and shamed
Reviewed by Muhammad Cohen
The roots of ‘Bailout Nation’
Commentary: Ritholtz book dissects crisis and Greenspan
By Howard Gold
Bailout study widens the “Big Picture”
Thu Jun 11, 2009 3:47pm EDT
By Pedro Nicolaci da Costa
Economics stories can be unexciting, but recent books try to keep their readers awake.
Miami Herald, Monday, 06.01.09
Las Vegas Business Press
Big bailouts a perversion of capitalism, author argues
October 05, 2009
Faux capitalists look for the free lunch
September 19, 2009
‘Self-Inflicted Damage’: Highlights From ‘Bailout Nation’
New Book From Bailout Critic Barry Ritholtz Takes on Citigroup, Chrysler and More
ABC NEWS Business Unit, May 27, 2009