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:
- For
every buyer, there must be a seller
- Let
winners run; sell losers short
- Respect
the trend, no one is bigger or smarter than the market
- Be
patient
- This
time is never different
- Always
go against the herd
- 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.
