Some Hard Truths About You and Your Money

Edges and anti-edges in the markets

The reader must forgive me for devoting three entries in a row to the financial markets. It was my intention when creating this blog to present essays on a wider range of topics, from Pakistan and Iran to the future of American power. But these are extraordinary times. And they call for an extraordinary response, not least from irrelevant bloggers.

As I write this, the markets have just closed in New York. Last week's breathtaking decline puts the S&P 500 43 percent off its peak a year ago. This places the current slump within striking distance of the second and third worst bear markets of all time, set respectively from 2000 to 2002 and 1973 to 1974.

Now is thus as good a time as ever to draw your attention to some basic market realities. Of course, they constitute the truth "as I see it." You are free to disagree. But most of these ideas are regarded as self-evident among successful traders. And they are principles you must be aware of if you are to avoid severe damage to your savings and an impoverished retirement.

Brace yourself; for most of you, what follows is not going to be pleasant to read.

Truth #1: Only a small minority of market participants can consistently make money over the long run. This is the essence of market speculation; ultimately, it rewards the few and punishes the many. If it were really that easy, you would see a lot more multi-millionaires walking around.

Truth #2: As soon as you buy a stock, commodity, or any other financial instrument, you are entering into competition against thousands of professionals. What is your edge? "Incidentally," notes famed market chronicler Jack Schwager, "if you don't know what your edge is, you don't have one."

In most markets, you can only make money by taking it away from other participants. These other participants are trying equally hard to take your money away from you. You must ask yourself what, exactly, your advantage is over the legions of large trading firms that staff hundreds of specialists equipped with proprietary software.

Truth #3: Buy-and-hold is not an edge. Let me repeat that: buy-and-hold is not an edge. This, of course, is contrary to what the financial industry tells you. If they are to be believed, you can profit over the long run by purchasing a "diversified" basket of stocks and bonds and holding them until retirement. Alternatively, you can follow the same strategy by buying into a mutual fund, which itself buys and holds any number of stocks, and "letting the magic of compounding turbo-charge your wealth."

The buy-and-hold concept is problematic for a number of reasons. First, as has become all too evident in the current crisis, plenty of the stocks you own may fall to zero while you're holding them. Second, there is no such thing as a diversified basket of stocks. In a bear market, they all tank together.

An even more serious problem is that the buy-and-hold philosophy is based on a myth. It is simply not true that stocks always go up over the long-run. Victor Sperandeo, a well-known stock trader, notes that if you bought stocks at any time between 1896 and 1932, you would have lost money by 1932. This is a 36-year period in which a buy-and-hold strategy failed.

However, you might object, that was a different era. The stock market has surely matured since then. No, it hasn't. If you bought at any time between 1962 and 1974, you would have lost money. By August 1982 the Dow Jones average was at the exact same level as it was in 1967. But the ravages of inflation over that period meant that a dollar invested in 1967 would have been worth a lot less fifteen years later. Currently, the S&P 500 is at approximately the same level as it was ten years ago.

Even in periods where buy-and-hold does work, such as 1982-1999, most people have a hard time sticking to the approach. Our natural inclinations lead us to buy at the highs, when hysteria is at its peak, and get out at the dead lows, as panic envelops the markets. As a result, people's actual performance in such periods tends to fall well below the opportunities the markets present.

This past week, the stock market plummeted to levels not seen since 2003. And it may still have a ways to go. Will the next 20 years be more like the 80s and 90s, or more like the 60s and 70s? Who knows? If you're buying and holding, however, you are leaving it to chance.

If you want to learn more about the often disappointing returns the stock market has offered buy-and-hold investors over the last 100-odd years, read Ed Easterling's sobering empirical study, Unexpected Returns.


Your anti-edge
If you are like most investors, you do not have any kind of edge that would allow you to grow your funds over time. What, then, does constitute an edge? There are many, and few of them are rocket science. An example would be systematically buying stocks that are going up and selling stocks that are going down. This is called trend-following, and it is a well-known strategy employed by many of the world's most successful traders. Another edge is to sell strength and buy weakness. This is counter-trend trading, the opposite of trend-following. Used wisely, it can produce plenty of profits.

To put these strategies into practice, you must surely render them more specific than the way they are outlined here. The point, however, is that they are actual strategies, made up of rules applied consistently across similar opportunities. This stands in contrast to trading on your whim, the method preferred by the masses.

Truth #4: Most people do not simply lack an edge. They possess any number of what might be termed anti-edges. That is, you are wired, by virtue of experience, beliefs, and genetics, to lose money in the markets. Here are some of the most common anti-edges.

Being human. Four decades of experimental research in behavioral finance has demonstrated, time and again, that we as humans are built to hemorrhage money in the markets. The golden rule of trading, as you may have heard before, is to cut your losses short and let your profits run. That is, if you are in a losing investment, sell it, and if your investment is making money, keep holding it. Our brains, unfortunately, are wired to do the opposite. As popularly disseminated as this finding is, it does not seem to be heeded; most people who encounter it believe it applies to everyone but themselves.

The reason that cutting losses and riding profits works is precisely the fact that it is psychologically difficult to do. As a result, most people cannot follow this maxim. If most people are not doing it, then the few who are will profit from it. This follows logically from Truth #1: it is the essence of markets to reward the few and punish the many.

Perhaps this is why studies have found that brain-damaged patients outperform individuals with normally functioning brains in financial investments. If you have brain damage, you are probably acting contrary to the majority of market participants. This is likely to help you profit.

If everybody suddenly started cutting their losses short and letting profits run, the optimal strategy would be to let your losses run and cut your profits short. But I don't expect that to happen anytime soon.

Investing on the basis of your common sense. If human nature leads you to make the wrong financial decisions, it does so by acting on your common sense. "Hey, everybody's wearing white headphones. I think I'll buy Apple." By the time you figure this out, chances are that others have too, and the opportunity is gone.

A better strategy might be the following. Post the Wall Street Journal stock listings to the wall, throw 50 darts at it, and buy the stocks the darts land on. Sell a stock if it drops 20% below your purchase price or, if the trade is profitable, exit it after three months. Why might this be an edge? Precisely because you are not making decisions in line with what human nature - and your resulting common sense - is telling you to do.

Possessing a graduate degree. In the financial markets, having a PhD can put you at a disadvantage. The same is true for a degree in law, medicine, or dentistry. People with advanced degrees are fodder for predatory brokers and financial advisers who flatter your intelligence in pursuit of commissions and fees ("you're a sophisticated investor; you deserve a solution that meets your demanding needs").

If you have one of these degrees, you are prone to believe you are more intelligent than most people. Even if you are, this has nothing to do with making money in the markets. The problem with intelligent people is that they have trouble admitting when they're wrong. As such, they are likely to hold onto plummeting investments until, finally, in a state of panic and dejection, they are forced to sell.

Having an MBA is even worse. For it spawns people who are not only intelligent but who consider themselves particularly shrewd when it comes to trading and investing. Most all executives of the Wall Street institutions that recently collapsed had MBAs.

I do not mean to say that everybody with an MBA is unsuited to market speculation. Many MBAs are smart, prudent risk managers and successful investors. I am instead referring to those people who believe they are better investors because they have an MBA. These are the ones who may one day find themselves on the wrong end of a bankruptcy receiver.

Being an avid reader of The Wall Street Journal. The WSJ is a tremendous newspaper. That does not mean you should use it to make investment decisions. Like a graduate degree, reading a financial newspaper on a regular basis can lead people to the erroneous conclusion that they are savvy investors. By the time it is in the newspaper, the opportunity is gone.

Watching a 24-hour news network, especially CNBC. These networks are toxic waste for your financial decision-making. The people who appear on CNBC are there because of their velvety voices and sound-bite sensibilities, not because of any higher power to offer profitable advice. Turn it off!

Investing on the basis of tips. A tip refers not only to a "hot" stock idea from a friend but also any advice from a broker or financial adviser about what to buy. If your financial adviser actually had good investment ideas, why would he give them to you? Why would he be working as a financial adviser in the first place? Good traders trade. They do not seek employment as financial advisers.

Investing on the basis of market history. This method is a little more sophisticated than tip-taking. It involves looking at past history, assuming the future will be like the past, and making trading decisions accordingly. An example: "National real estate prices have never gone down. Therefore, they will never go down." This was the belief of traders and executives in many Wall Street institutions that are no longer with us. In the markets, things that have never happened before happen all the time. (For more on this, see my previous post, "Financial Market Chaos Explained.")

Handing your funds to a "money-manager" such as a mutual fund. The problem with mutual funds is that they follow a buy-and-hold strategy. If the stock market doesn't go anywhere for the next 15 years, chances are any money you place with a money manager won't either.

Investing without any background in statistics and probability. If you intend to speculate, you need to have a basic grasp of such concepts as standard deviation, expectancy, and probability distribution. If you don't understand them, you are putting yourself at a disadvantage to those who do.

Investing with too much background in statistics and probability. Be careful. Many conventional statistical methods are downright dangerous when applied to the markets (again, see "Financial Market Chaos Explained"). If, in your studies, you ever come across the word "normal distribution," run.

Not having a preconceived exit point. This is perhaps the most hazardous anti-edge. When you buy a stock, or any other investment, and you have not already specified the conditions under which you will sell it, you are setting yourself up for disaster. Note that the decision about when to exit must be made before the trade is entered. Otherwise, you end up having to make on-the-fly judgments in the midst of battle, when your irrational human emotions are at their peak. You must actually have two exits - one in the event that your investment loses money, and another for taking profits.

Most people do indeed use exits. Two of them are particularly popular. The first is to sell when you need the money. Of course, you must hope the investment is still profitable by the time you reach that point. The other method is to wait until the value of the investment goes to zero. This is the exit type that comes most naturally to the majority of people; at least you don't have to pay any capital-gains taxes afterward.


Is there an easy answer?
The good news is that most all of the anti-edges boil down to your beliefs. Do you believe you can invest successfully using your own common sense? Do you believe you are more intelligent than most people, and that this gives you an edge in the marketplace? Do you believe you can consistently find profitable investment opportunities by reading a financial newspaper every day? All you really have to do is change your beliefs. If you manage to do that, you just may have a chance.

The bad news is that finding a real edge that is right for you can take a lot of work. And applying this edge successfully over a long period of time often requires a degree of psychological introspection with which many people are uncomfortable.

Just remember this: if you do choose to put your money anywhere besides US Treasuries, you have now joined the ranks of the speculators. And you had better learn what you are doing. A great place to start would be Market Wizards and The New Market Wizards by Jack Schwager. They are a fascinating series of extended interviews with top traders. If nothing in these two books really grabs you, then you probably have no business in this business.

There are many other good books out there that touch on important aspects of trading strategy development, trading psychology, and building a trading business. Among the best I've encountered are The Psychology of Trading and Enhancing Trader Performance by Brett Steenbarger; Mastering the Trade by John Carter; Trade Your Way to Financial Freedom and The Definitive Guide to Position-Sizing by Van Tharp; Way of the Turtle by Curtis Faith; The Evaluation and Optimization of Trading Strategies by Robert Pardo; The Complete Guide to Building a Trading Business by Paul King; Technical Traders Guide to Computer Analysis of the Futures Markets by LeBeau and Lucas; Winner Take All by William Gallacher; Smarter Trading by Perry Kaufman; Trading for a Living by Alexander Elder; Street Smarts by Connors and Raschke; and Evidence-Based Technical Analysis by David Aronson. I also highly recommend the numerous home trading courses offered by Van Tharp's International Institute of Trading Mastery.

I am personally skeptical that you can make money consistently by adopting someone else's strategy and putting little work into the process yourself. If it is possible, then the only reliable place I know of where you might find an answer is Tharp's book, Safe Strategies for Financial Freedom, along with his weekly newsletter. His focus, like that of all the authors listed above, is not on giving tips but rather following an established set of rules for when to buy and sell. Check it out for yourself.

If you do not take the time to learn what you are doing, you are setting yourself up for frustration and failure. You are better off sticking your cash under a mattress.