Know thyself and thy limits to tame dreaded black horsemen
• Investors come in a number of guises and knowing which one you are can spare you anguish
One of the more pertinent analogies for today’s markets is George Goodman’s comparison of high-flying markets to “a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air”.
“We know at some moment the black horsemen will come shattering through the terrace doors wreaking vengeance and scattering the survivors,” Goodman writes in his book The Money Game. “Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time. So everybody keeps asking — what time is it? But none of the clocks have hands.”
The problem with leaving the markets too early, of course, is that you end up missing out on more than just champagne and summer air.
According to Reuters, in the first five weeks of 2014 investors removed more money from emerging-market funds and exchange-traded funds than they pulled out in the whole of 2013. By then, emerging equity funds had suffered 15 straight weeks of outflows.
But, as Joshua Brown points out in a subsequent article at The Reformed Broker, after what eventually became a 14-week period of continuous outflows, the emerging markets went on to smash the MSCI World Index for the next four years, with average annual returns of 30% compared with the long-term average of 17%.
As the saying goes, the stock market is like God or providence. It has its own mood and flow. Be with it and you will be rewarded. Move against it and you’ll be sorry.
Or, as Futures Hall of Fame inductee John Henry put it when explaining his strategy: “I knew I could not predict anything, and that is why we decided to follow trends, and that is why we’ve been so successful. We simply follow trends. No matter how ridiculous those trends appear to be at the beginning, and no matter how extended or how irrational they seem at the end, we follow trends.”
Brown says: “The efficient market guys will tell you that rational investors will allocate based on where the greatest expected returns are and that capital flows will follow value. This is actually the exact opposite of how the markets really work in practice.
“Over long stretches of time, we can say that money is eventually allocated efficiently — but the journey to get there is where trends and volatility come from. In other words, the efficient market isn’t a state of being — it’s a verb, a process. In the short to intermediate term, flows don’t follow value, they follow performance. They chase it. Each week witnesses money being thrown at whatever has worked best during the prior week.”
If that’s the case, why repeat until broke? On the other hand, if no one knows when those “black horsemen” will come through the door, when is the right time to get out?
The answer lies in investors asking the right question: not when they should leave the ball — if at all — but whether they have what it takes to stay.
As Jason Zweig explains at The Intelligent Investor, the financial industry has traditionally sorted investors into three types: conservative (willing to tolerate very little risk of loss); moderate (willing to take some risk); and aggressive (prepared to withstand high risk).
However, Benjamin Graham, the founder of modern investment analysis, didn’t believe in differentiating people in that way. Instead, he divided investors into two types: defensive and enterprising.
Defensive investors, Graham argued, want to avoid “serious mistakes or losses” and seek “freedom from effort, annoyance and the need for making frequent decisions”. Conversely, enterprising investors are willing “to devote time and care to the selection of securities that are both sound and more attractive than the average”.
Enterprising investors will consistently monitor the markets in the hope that a substantial fall will present bargains. Defensive investors are perpetually monitoring themselves.
If you’re not bothered by significant market gyrations, there is no compelling reason for you to change course right now. But if you find yourself gasping every time the market does a single-digit move, you might want to consider trimming back on stocks in favour of cash and bonds. You should also keep in mind that our risk appetite fluctuates depending on events and circumstances — it does not remain static, and the assumption that you will think and act rationally at the extremes is often not the case.
You don’t want the next big fall in the markets to be an expensive way for you to find out who you really are. Whoever said the market is always appealing, challenging, fascinating, captivating and mystifying forgot to mention that it’s occasionally darn right nasty too.
As Alexander Elder reminds us at Trading for a Living, the first goal of money management is to ensure survival.
You need to avoid risks that can put you out of business. The second goal is to earn a steady rate of return, and the third is to earn high returns — but survival comes first.
“‘Do not risk thy whole wad’ is the first rule of trading,” says Elder. “Losers violate it by betting too much on a single trade. They continue to trade the same or even a bigger size during a losing streak. Most losers go bust trying to trade their way out of a hole.
“Good money management can keep you out of the hole in the first place. The deeper you fall, the more slippery your hole. If you lose 10% you need to gain 11% to recoup that loss, but if you lose 20% you need to gain 25%to come back.
“If you lose 40%, you need to make a whopping 67%, and if you lose 50%, you need to make 100% simply to recover.”
You have to know in advance how much you can lose — when and at what level you will cut your losses. Professionals tend to run as soon as they smell trouble and re-enter the market when they see fit. Amateurs tend to hang on and hope.
Amateurs tend to ask what percentage profit they can make annually from trading. The answer depends on their skills and market conditions.
But amateurs seldom ask the more important question: “How much will I lose before I stop trading and re-evaluate myself, my system and the markets?”
YOU DON’T WANT THE NEXT BIG FALL IN THE MARKETS TO BE AN EXPENSIVE WAY TO FIND OUT WHO YOU REALLY ARE