Alan's Alert 8-3-2021

 

A question that has plagued new investors for time immemorial is, how do I make money in the stock market?  Volumes upon volumes of books have been written on the topic.  Many well-known, some not as popular.  Possibly the most famous is Ben Graham’s book, “The Intelligent Investor”.  Ben Graham was Warren Buffet’s mentor.  Ben’s work has influenced an untold number of investors, but making money in the market doesn’t always equate to following someone else’s formula.  The question of making money in the market can be boiled down further into: what determines which stocks go up and which go down?  This question is solved by economics 101, supply and demand.  When the supply of buyers is large and the number of sellers is small, the price has to go up to find an equilibrium.  The same is true in reverse.  If the quantity of sellers is large and the pool of buyers small, the price must go down to find equilibrium.

So, we want to find stocks that have a large pool of buyers and a small pool of sellers.  How do we find these stocks?  This line of questioning begins to lead us into the psychology of the participants of the market.  Lance Roberts of RealInvestmentAdvice.com said it best when he said, “Price measures the current psychology of the herd and is the clearest representation of the behavioral dynamics of the market.”  What Lance is saying here is that the herd (a large pool of buyers) controls the price of a stock and that price reflects the current mindset of the herd.  If the herd has been whipped into a buying frenzy, the stock could skyrocket.  If the herd has concerns about the future profitability or other’s opinions on the stock, the stock could plummet.

The true key to profits in the market then is this: buy the stock before the herd and sell before they change their minds.  Amazing right?  You simply… buy low and sell high.  This worn-out phrase has been around forever.  Unfortunately for most, they struggle to determine what “low” means and how to define “high”.  Just because a certain stock looks high-priced, does not mean it is “high”.  This also works on the flipside; stocks priced cheaply are not necessarily “low”.  In Daniel Kahneman’s book, “Thinking Fast, & Slow”, he looked at investors who thought they were buying low.  What he found was that individual investors liked to “lock-in” their gains by selling the “winners” and that they would hang on to the “losers”.  However, the recent winners had a tendency to do better than the recent losers in the short run.  This leads to my second trading rule, “Let winner runs; sell losers short”.  You do not want to get stuck with a loser in your portfolio.  This is why a stop point is important.  Once the trade has gone against you, you need to have a system for selling it.  Whether that is a percentage loss or a time frame is up to the individual investor.  Losers in your portfolio not only influence your trading mentality but they are a drag on your portfolio.

It is important to respect the herd’s current mentality when it comes to the price of a stock.  The herd determines the trend and the trend is your friend.  No one is bigger than the herd and no one can run against the trend.  You may feel that you know something the herd doesn’t.  We could know with certainty that inflation we are witnessing is perpetual and that gold is the place to be to preserve buying power, however this doesn’t mean the herd will change its mind.  The herd can run against you and make you bankrupt before it changes its mind.  This is why patience is so important.  There should never be a rush to make an investment and there is nothing wrong with sitting in cash until a good deal comes along.  This isn’t baseball.  We don’t get called out after 3 strikes.  We can look at 20 strikes before we decide to swing.  We could look at 100 strikes.  The only way to get called out in this game is if you run out of capital.

“Don’t worry about missing a rally.  Worry about losing your money” – Dr Michael Burry

 

Without further ado, here are my seven trading rules:

1. For every buyer, there must be a seller
2. Let winners run; sell losers short
3. Respect the trend, no one is bigger or smarter than the market
4. Be patient
5. This time is never different
6. Always go against the herd
7. Know yourself

 

You know the rules, and so do I.  So, let’s...

In July, Planet Money, a podcast put on by NPR, recently dove into their archives and uncovered a gem.  They remastered a classic and re-posted it to their website.  It’s called, “The Great Inflation Classic” and has a great look into the mentality of herds.  I highly recommend a listen.  They interview Paul Volcker and question why he had to raise interest rates as high as he did.  The plain and simple answer, to break the herd’s mentality that inflation would continue.  In time, we could see the herd’s mentality surrounding inflation change again.