Friday, December 10, 2010

"Markets trade on human emotion, not logic."

This is a statement made by the author of a book I am reading entitled The Layman's Guide To Trading Stocks (it was sent to Glenn recently). I got out of the stock market months ago but have thought about getting back in at some point, so I thought this book might give me some tips. It definitely did. The author, Dave Landry, doesn't offer a system for buying and selling, but rather a "common sense approach to markets."

As I read through the chapters, a lot of Landry's advice rang true for me. He starts out stating that "You need to change the way you think about Wall Street." He highlights the myths and truths along with charts and facts to back them up. For example, Wall Street Myth #1 is: "The Market always goes up in the long term." How many times have I heard that? More often than I care to remember. Landry points out that markets do not always go up longer term. He gives examples:
Suppose you bought stocks in 1929 at the market peak. Provided you could have held through a 90% loss, it would then have taken you a quarter of a century just to get back to breakeven....

Let's say you bought stocks in the mid-1960's. Your return would have been almost zero until the market finally broke out in 1983, which was 17 years later...

So the market does not always go up in the long term and buying and holding does not always make sense, though that is often the prevailing wisdom.

The book also shares a number of "truths" about the market that make sense. One that I found interesting is that "The markets trade on emotions":

Stocks trade on emotions, period. They do not trade on reality. Stocks trade on the perception of reality, which is driven by human emotions. From the large institution down to the layman, the buying and selling of stocks is based on fear and greed--that is emotion.

So how do you read the emotions? You simply look at the charts.

Okay, at the charts statement, he might have lost me but he seems to have very clear and easy to follow charts about the market that make sense. The book is very easy to read, easy to follow and hopefully, will get me back involved in the market using baby steps or at least allow me to wade back in without losing my shirt.

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11 Comments:

Blogger Der Hahn said...

Those examples really do not prove the statement 'The market doesn't go always up in the long term' since he helpfully points out that if you held the stocks long enough before selling (what I would generally consider to be 'long term investing') you would have realized positive gains. It's certainly useful to remind people that stocks can and do lose money, especially between arbitarily selected time periods, but it's hardly earth shattering news.

9:45 AM, December 10, 2010  
Blogger David said...

I believe it was Warren Buffett who observed that in the short term the market is a voting machine, but in the long term it is a weighing machine. Emotion can only overcome reality for so long: sooner or later, financial realities dominate.

A very good thinker on market-related matters is fund manager John Hussman.

10:10 AM, December 10, 2010  
Blogger DADvocate said...

I listen to these two guys on Cincinnati radio fairly regularly. Almost every show they bring up how emotion affects the market. It is common to hear them say how a rally or fall is not supported by the facts but rather the result of hope or fear based on some government announcement that day or other bit of news.

10:27 AM, December 10, 2010  
Blogger dr.alistair said...

there are philosophical positions regarding something for nothing, which are outside of the point of the post, but the fact remains that "investment" in the stock market is a gamble, unless you know precisely what is going to happen to the value of a stock over time...which we all know is illegal.

many coffee shop experts have their ideas about what to do next, but most fall back on historical examples to try to make their point.

...and the market really does always go up over time, but remember, the value of commodities is a game that is centuries old.

many investment houses have an odds-and-sods guy on staff, who`s job it is to monitor self directed stock purchases on the board, i.e. those made without broker`s advice.

the reason why these purchases are tabulated is that they are 80% losers. a good piece of information to have.

the best book on investing i ever read was called rampaging bulls, in which it was explained that the stock market is a criminal racket, but that there is money to be made if you understand which stocks are being promoted (manipulated) and when...otherwise you are gambling (slowly losing).

1:32 PM, December 10, 2010  
Blogger BobH said...

If buying at regular intervals and holding the market is a bad idea, trying to "time the market", i.e., buying and selling when it seems like the right thing to do, is an even worse idea. The majority of managed mutual funds can't beat the S&P 500 in any given year and their fund managers are paid big bucks to try. Or maybe they're paid big bugs to come up with plausible excuses why they fail.

10:40 PM, December 10, 2010  
Blogger Counter Trey said...

The best investing book is The Intelligent Investor written by Benjamin Graham in 1949. That is the book that Warren Buffett read soon after it was published and got Warren on the train out of Omaha to Columbia University where Graham taught. Buffett attributes almost everything he know about investing to Graham.

In the book you will find two pieces of investment wisdom that many experts who came after Graham simply rehash in their own words: 1. The metaphorical "Mr. Market," a manic depressive that Graham advises investors exploit. Buy from him when he is depressed and sell to him when he is euphoric.
2. The concept of only buying when you have a margin of safety.

You can find the book on the second page of my Blog's Value Investing bookstore at Amazon:

www.amarginofsafety.com

1:16 AM, December 11, 2010  
Blogger Counter Trey said...

...Oh, and I am a big fan of your blog Dr. Helen...

1:17 AM, December 11, 2010  
Blogger don said...

I concur w/ CounterTrey as to his book reference, though quite heady. A better alternative might be getting educated through a nonprofit investment club group www.betterinvesting.org that are folks just like us who have joined together most often in clubs to educate themselves on stocks and such and have no 'ulterior' motive for opinions one way or another. You don't want to be dumb in stocks nor depend on brokers who are just simply into sales and commissions. Using their educational and analysis tools i have over the past bad investment years able to outgrow what i had with the 'broker' such that i am now free of the broker completely and much smarter and financially better off for it (even though i kept half off the table in fear). While it 'seems' to make sense to be 'out' of the market as these times are so wacko, it reminds us of saying that you buy when all are afraid and sell when all are without fear. I use another related site to screen stocks and then use 'bi' tools to evaluate whether the stocks have a margin of safety, then decide and been quite satisfied with results. We need heed out own words and philosophy and take responsibility for our financial and investment decisions, of course. Besides investing purely in my own business, this is it. By the way, B
I site is free access this month and has lots to offer ....and without bias. This is great, again... because this area is one of the hardest arenas to get good, unbiased solid advice.

9:40 PM, December 12, 2010  
Blogger dave said...

The Warren Buffet argument always comes up whenever someone claims that buy and hold doesn’t work. Getting back to my “don’t take my word for it, look at the charts” comment, you’ll see that Mr. Buffet’s fund, Berkshire Hataway (BRKA), lost nearly half of its value in the bear market of 2007-09—Just like the market itself. In fact, over the past 20 years, if you overlay the S&P 500 with BRKA, you’ll see that there is a very strong correlation. The market goes up and so does BRKA. The market goes down and so does BRKA. This is especially true in more recent times (e.g. the aforementioned 50% drop in the market and a corresponding move in BRKA). I’d venture to say that the next 20 years that the performance would continue to equal the overall market. So, if we he another 20-25 year period where the market doesn’t make new highs (as discussed in the book), I’d be willing to bet that BRKA would do the same. Further, in more recent times, Mr. Buffets “buy and hold mantra” has come into question due to his many short-term/derivative type of deals (source Covel’s Trend Following).
I stopped short of mentioning Mr. Buffet directly in the book because of his “sacred cow” status. However, it now appears that I am being forced to address this. I think my best argument remains “don’t take my word for it, look at the charts.”

Now, as far as short-term vs. long-term, I think the following excerpt explains my mentality:
When predicting the weather, the longer your forecast, the tougher it will be to get it right. If it is cloudy and thundering, chances are it is going to rain soon. However, this obviously does not mean it will be raining this time next week or next month. Similarly, although market forecasts are based on probabilities, predicting short-term moves is much easier than predicting the longer term. Furthermore, the longer you are in a market, the better the chances are that you are going to get soaked. Short term trading keeps risks relatively small due to limited length of exposure.

By now you are probably thinking that I am building a case for short term trading. I suppose that to some degree, I am. But even though short-term trading has advantages, it also has disadvantages. The biggest is that gains are limited by the brief exposure to the market. Big trends often take time to develop. The real money is in longer-term moves.

If long term trading has bigger opportunities but risks too much and short term trading has smaller risks but does not make enough, what is a trader to do? Simple, it is not a mutually exclusive decision. Why not trade for short-term gains but be willing to stay with a portion of the position as long as the market moves in your favor? This allows you to have your cake and eat it too.

Considering the above, I seek out stocks that have the potential for both a shorter and longer term gain. My goal is to capture a small, quick profit but keep a portion of the position as long as the market continues to move in my favor. Although I have been slotted as a swing trader, I like to see myself as a longer term trader with better timing and money management. Like Hanna Montana, my approach has the best of both worlds.

Dave Landry
dave@davelandry.com
www.davelandry.com
www.thelaymansguidetotradingstocks.com

9:57 AM, December 13, 2010  
Blogger JG said...

"In fact, over the past 20 years, if you overlay the S&P 500 with BRKA, you’ll see that there is a very strong correlation. The market goes up and so does BRKA. The market goes down and so does BRKA."

-----

The key point, however, is that Berkshire Hathaway goes up slightly more when the overall market goes up and goes down slightly less when the market goes down. In other words: it beats the market on a long-term basis, which most funds do not do.

Frankly, the only investment method that "works" (i.e. beats the overall market) is the value investment method (buying undervalued stocks according to the Graham and Dodd valuation methods outlined in Security Analysis).

Technical analysis (chart reading) is akin to reading tea leaves.

10:38 AM, December 13, 2010  
Blogger JG said...

There have been studies on chart formations using previous data. One that I am aware of involved the "head and shoulders" formation. Supposedly after a 10% drop from the last shoulder, the stock is much more likely to go down further.

But it doesn't - not any more than chance.

10:41 AM, December 13, 2010  

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