The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

06 December 2009

One Pilgrim's Progress

Some readers wonder whether I overstate the importance of psychological issues in the quest for consistent portfolio success. ("Aren't trading strategies and skills more important?") Surely, without sound, reliable methodologies, an investor cannot hope to be profitable. And yet I believe that an investor's psyche to be more important than consummate skills to achieve consistent and enduring success. You can know all the patterns, have all the skills, and yet remain unable to pull the trigger.

There are key ways you can cultivate the proper mental edge.

Remain calm and relaxed. You should manage risk on each investment. If you truly know that an investment, held currently at a loss, has relatively little impact on your account balance, you will be more easily able to remain calm.
Attitude. Many investors are afraid to face the worst-case scenario, which is that they cannot invest profitably, or that they will ever achieve lasting success. Do not be afraid to face your limitations; instead, work around them. With realistic optimism, you can beat even the most seemingly insurmountable problem.
Focus on the process, not the result. Many investors become bogged down because they focus on making big profits. You end up putting extra pressure on yourself to perform beyond your skill level, and when you do that, you usually choke under the pressure. It is better to focus on the process of investing. Focus on learning how to invest correctly and profitably rather than on the extrinsic, monetary rewards of investing.
Focus on meeting your own internal standards. Better than to measure your portfolio performance against other investors for how well you should be doing. Everybody has his or her own unique learning curve. Some people pick up investing relatively quickly while others need to spend a great deal of time honing their skills. Do not make the mistake of thinking that just because you are not doing as well as other investors that you have less talent or are doing poorly. Your timeline is different.

Investing is difficult enough, but the multitude of methods can be downright stunning. Just look at your choices: stocks, futures, options, mutual funds. Then you have to determine an appropriate level of activity: day trading, swing trading, buy-and-hold. Even your strategies are numerous: scalping, spreads, system trading, directional. It is easy to be overwhelmed. One of the major pitfalls of active trading is trying to master all of these choices.

Smart investors give themselves an edge by doing one thing well. Plenty of traders have made fortunes just buying and selling one stock repeatedly. Others have mastered the art of options spreads, while some have even profited from the reversals that often occur after news events push a market to an extreme. But nobody has ever made a consistent profit by trading all investment options.

Many examples abound why it is better to focus on one theme, but consider the advantages of mastering one single stock. The popularity of computerized systems trading is growing, but these 'systems' can be somewhat misleading to a naïve investor. The criteria set that works great for one equity could be disastrous when applied to another. The idea here is universal; if you want to be a successful investor, you must give yourself an edge. You can do that via mastering one stock, one trade, or one signal, and then execute it perfectly. Remember, investing accurately is more important than investing frequently. Thus, it is more crucial to invest with confidence rather than skill. You must take action when the moment is ripe, not rotten. And only you (your mind, your outlook, your psychology) holds yourself back from consistent success.

We all, as humans, are risk averse. We have a strong need to seek out pleasure and avoid pain, which means in this context that we do not like to incur losses from our investment efforts, and we'll do almost anything to avoid taking them. Losses are painful; investors tend to come up with many ways of denying a loss -- such as holding on to a losing investment and hope it turns around. In the end, though, you will invest more efficiently and profitably if you can take losses as quickly as possible, and then make a new investment. The best way to do this is to have a clearly defined investing plan in which you pre-define the reasons you will enter and exit an investment. Once you have such a plan, you then can execute the investment without hesitation: Nothing to consider, weigh, or judge and consequently nothing to tempt you to hesitate and be consumed with self-doubt. The best way to take a loss is to anticipate it. Do not be caught off guard. If you invest with the expectation  an investment opportunity could lose, you won't be as bothered should the investment go against your hopes; if you avoid considering the possibility, you'll become extremely frustrated when you are in the midst of a losing investment. Accept that losses are the norm rather than the exception, especially the briefer your time frame to fruition.

The problem becomes that we each want to own the big movers, the stocks that grab the headlines; unfortunately, this attempt often gets in the way of our making money. This is a fantasia that continues to plague me, despite my decades-long attempt to corral it. I scan the markets to determine what moves now, and moan that I am not aboard. If I, or you, were to suddenly jump aboard this or that runaway train, then what knowledge do we have regarding the company? When things go wrong (usually expressed as the stock declining suddenly and ferociously) we are left with only the questions we should have asked before buying into the position. Oh, and the loss.

So I develop a list of companies I want to own, and from that list I await my moments of opportunity to purchase. While I wait, I study the company and watch how its shares trade: each stock has its own peccadilloes that betray something, no matter how inconsequential for a specific time frame. And while I am busy doing all that, other stocks on my buy list are moving. In fact, stocks are moving all the time — I merely await the pattern or setup with which I am familiar or comfortable. When that occurs, I act.

I am wrong so often, it hurts. Trading, speculation, investing (recall I denote the critical difference as one of time) are, in themselves, each sufficiently difficult not to complicate the matter by conflating your emotional vacillations with the market's oscillations. If something goes wrong, sell and move on; if something goes right, then sell and move on. But this is difficult, isn’t it? Who wants to admit to being wrong by stopping out for a small loss when, if we grant enough time, it will go up… Right? And who wants to take a profit, large or small, when, if granted enough time, the stock will go higher, much higher. ("I had it when.")

Give it up. The effort is not to buy the low tick or sell the high tick, or even having owned it whenever, but for your portfolio to amass an increasing value. Does it matter how it got there? It is for this core reason that I fixate on investor's psychology: 99% of success in this venture is based upon your decisions, not the market’s oscillations.

Knowing everything about a company merely serves to whet our appetite, but little about its shares; whether now is a good time to buy, a recognition of your time frame and tolerance for risk. No one other than you can answer those questions; the answers are internal not external. After analyzing the company and considering it a fit for your portfolio, you still must determine how many shares, when to buy (and sell), and when do you recognize the error of judgment based on either (or both) the stock and the company. LaPlace said, "The most important questions of life are, for the most part, really only problems of probability." In the face of this uncertainty lies your prowess to make decisions now.

Stocks oscillate. But if you buy stocks that trend upwards, then weakness in the general market should result merely in short term weakness in your up trending stock; i.e., a buying opportunity. The trick is to recognize when a trend is about to reverse from up to down (or down to up). Because the effort to buy during a decline is difficult, you might find buying higher easier to accomplish. Of course, this also potentially means that the moment you finally feel comfortable buying is the same moment you should sell.

The problem is the amount of volatility within the existing up trend. Any investment is a difficult hold for the emotional investor. If the potential opportunity for an investment excites you, what do you do about it? Do you buy, and grimace through the gut-wrenching volatility? Despite your recognition of the company’s opportunity, and its proven success in the market already (evinced by a rising share price), who wants to buy in advance of a sudden sharp decline in price? And before the trend resumes?

At some price or level, the shares represent value to you, irrespective of any additional downside volatility subsequent to your purchase. So you buy then because the investment is appropriate for your portfolio, and further price weakness is inconsequential to the opportunity you foresee.
-- David M Gordon / The Deipnosophist

PS: Please visit Investment Poetry for specific investment opportunities, price and timing included.

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