In the long run, stock markets are one of the best places to invest for profit. Yet stocks and shares leave a lot of people wide eyed with fear. This is not least because the big money is controlled by market professionals. Plus price swings can be wild at times, with serial bubbles followed by inevitable crashes. So this fear is understandable, but it usually leads to poor investment decisions. But if you take the right approach you can substantially reduce the risks and even beat the pros at their own game.
As a market “outsider” you have some serious disadvantages when compared to full time market professionals. The good news is that if you take the right approach to investing you can give yourself some major advantages over those same market pros.
First and foremost, as a private investor you need to to forget any attempt at building your strategy around short term trading and speculation. Many brokers and financial newsletter writers lay out strategies of this nature, always with an eye on sales. But they always gloss over the raft of reasons why they ultimately don’t work.
In short, as a private investor you have much less time to spend studying markets than the pros. Also you have worse information (or later access to it), much higher transaction costs such as commissions, and worse pricing – you buy higher and sell lower than the insiders.
In a former life I worked for a huge global investment bank over a span of 15 years. Yes, yes, I know. Bankers and ex-bankers are almost universally hated these days. But trust me, not all of us are bad. It’s just a significant minority that are – as in any walk of life. And my experience within that industry gives me insight on how to deal with it, which I can then pass on to you.
One of my ex-employer’s claims to fame was that it traded the biggest volume of stocks in the world. It was number one or two in practically every major market across the globe, from New York to London, Paris, Frankfurt, Moscow, Hong Kong, Singapore, Jakarta, Tokyo or Sydney, to name just a few. No other investment bank or broker was even close.
Sitting inside a somewhat dull looking building in suburban Connecticut, in the USA, was one of the bank’s trading floors. It was claimed to be the largest in the world. To accommodate this money moving machine the bank had built in a room that could be compared to a huge aircraft hangar. The floor size was much bigger than a football field and the ceiling was several stories high. At one end there was a huge raised boardroom where senior managers impressed clients by showing them the vast vista of money on the move.
Down on the floor hundreds upon hundreds of traders, analysts and salespeople sat in tightly packed clusters of desks. Each of these people was hunched in front of a collection of computer screens for around ten hours a day.
They used their specialist knowledge either to trade for the bank’s own account or to persuade clients to trade for a commission. Most of them had specialised in their chosen field for many, many years and sometimes decades.
Every single one of this hunched mass was a highly paid specialist in some tiny corner of the markets. They used their specialist knowledge either to trade for the bank’s own account or to persuade clients to trade for a commission. Most of them had specialised in their chosen field for many, many years and sometimes decades. By comparison, all of the rest of us are amateurs when it comes to the finer points of market mechanics.
(By the way, it was an in-house joke that we called the trading floors “glorified call centres”. The people may be paid hundreds of thousands of US dollars a year, or even millions in some cases. But a lot of their jobs involve tedious and repetitive work and answering the phones.)
That was just one trading floor, in one country, in one large investment bank. Similarly huge operations populated by similarly hunched beings whirred away in London, Zurich, Hong Kong, Singapore and Tokyo – plus smaller presences in other capital cities (the bank had offices in something like 60 countries, if memory serves).
Add it up and it meant that this one bank alone had thousands upon thousands of people spending most of their waking hours studying every detail of every part of the traded financial markets. That’s 24 hours a day, every day that the markets were open for business.
In many cases the traders played tag team, as traded portfolios were passed on at the end of the day to be managed by another team on another continent, eventually circling back to the start location when the traders were back at their desks the following morning. The bank never slept, and trades were never left untended during market hours.
Again this is not something that you or I can do with our own portfolios. Even if we didn’t ever sleep, there are much better things to do than watch markets and news feeds all day (and night) long.
Remember, the trading floors I described were from just one bank. Add in the many other large investment banks and smaller brokerage firms and we’re talking about tens, maybe hundreds of thousands of highly motivated, highly paid people who do nothing but watch tiny specialised niches in the world’s securities markets. Plus this is just the “sell side” that I’ve talked about so far, to lapse into industry lingo.
At the same time there are the countless thousands of similar professionals toiling away at hedge funds, pension funds and insurance companies – the so-called “buy side”.
…these people all have one single thing on their minds most of the time: how to get money out of each other and out of their end customers – and that means you and I.
Whichever side of the market fence they sit on, these people all have one single thing on their minds most of the time: how to get money out of each other and out of their end customers – and that means you and I.
If you want to be a short term trader and try to compete with that monster money machine then I wish you luck. A lot of luck. You’ll really need it. Those that try this are being, ahem, “optimistic” to say the least. I strongly advise that you don’t go down that route.
However, beyond the challenge of competing with the pros there’s another major thing that puts people off stocks. Anyone who’s studied or invested in stock markets for any length of time knows that price moves can be sudden and large. In fact market crashes are pretty regular occurrences.
Benjamin Graham is the man credited with being the “father of value investing” (he was a mentor to Warren Buffett amongst others). In chapter three of his famous book “The Intelligent Investor” Graham summarised in a table all the major US stock market swings between 1871 and 1971. (The book is a relatively easy read although quite long. We recommend it to all OfWealthers as a great investment primer, even if you only get through the first half. Go for the third edition published in 1973.)
The data shows 15 major US stock market declines in the space of 10 decades. Put another way, on average markets headed down every six years and eight months. The average price fall was 36%, ranging between 15% (1952-1953) and 86% (1929-1932).
Also, only one decade saw no major price declines, and that was way back in the 1870s, right at the start of the time series. So arguably there were 15 major declines over nine decades, which reduces the average time between when they started to just six years.
This record of market cycles is a note of caution for the current crop of US stock market bulls. The market has been heading up since early March 2009, or just over six years. That’s close to the average time between downturns over the past century. Not to mention the very extended valuations at current market prices.
Despite the constant cycle of bull and bear markets, every time a stock market falls a lot we see breathless headlines about how the world is ending – or at least the investment world. But the historical record clearly shows it’s just part of how markets behave. There are cycles, gyrations and market swings, sometimes violent ones. Just like a rollercoaster, it scares the hell out of a lot of people. But once you get used to it you can learn how to enjoy the ride.
Prices are sometimes driven by fundamental conditions – such as economic booms and busts. But just as often they are pushed around by fashions, fads and animal spirits – such as a belief in new technologies, debt fuelled speculation, or the perceived power of central bankers to rewrite the rules of economics (or a combination thereof).
Late stage bull markets – when prices have been rising strongly for years – are the riskiest time to invest in stock markets. Ironically this is the moment when most investors – especially small investors – feel most relaxed and therefore inclined to put their money into shares.
That’s because almost all financial news strikes a positive tone, and constantly spreads the message that if you don’t jump on board you’re going to miss out. But getting in late in the game is a big mistake because you’re likely to be paying the highest of prices for what you buy.
…it never ceases to surprise me how short people’s memories are. But there are plenty of propagandists around to help along the collective amnesia.
When it comes to investing, it never ceases to surprise me how short people’s memories are. But there are plenty of propagandists around to help along the collective amnesia. Professional market cheerleaders are surprisingly adept at creating plausible new theories and justifications for why prices will keep on rising. They are almost always wrong. (“It’s a new paradigm for a new economy….”, “The central bank will keep printing money…”, “Stocks always rise when interest rates go up…”, and so on…)
At the other end of the scale, when the market has just crashed, most people see stocks as incredibly risky. Something that they wouldn’t touch with a dirty stick. But, again, the irony is that this is the best time to invest in this asset class. When it’s cheap and hated.
So how do we, as private investors, avoid getting burnt by these cycles and the market hype? Well, the truth is that no one – and I really mean NO one, not even the very best professional investors – gets it right all of the time with every investment that they make.
But if you understand some fairly basic things, set a strategy based on them, and stick to that strategy, then overall you will come out well ahead of the pack. You’ll lose some, but you’ll win most.
So all is not lost. Quite the contrary. Just because you can’t be a successful short term trader of stocks, or because markets have a tendency to boom and bust, doesn’t mean you can’t be a highly successful long term investor. In fact you have some major advantages over the pros if you know how to go about it correctly. Part II will explain how.
Stay tuned OfWealthers,