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Archive for July, 2011

How To Play The Stock Market Game

Investing is not really a game, but your success as an investor depends on how well you understand the basics of “game theory.”  The poker game analogy will be useful as we work our way through the mechanics and strategy of investing.  We chose this because the game of poker has some important similarities to investing.  For example, you are competing against other investors who may be more skilled than you, may have more money than you, or may have better information than you.  The goal of investing, as it is in the game of  poker, is to avoid getting wiped out while you wait for opportunities to win big pots.  Some of the topics we will discuss here include:

  • Rules of the game
  • The players
  • Correct strategy
  • When to cash out

Rules of the Game

  1. Investing is a Zero Sum Game.  This means that for every winner, there must be a loser.  That’s because every time you buy a stock, there is someone else on the opposite side of your trade.  When you buy a stock, you are making a bet that the price will go up.  But the person who is taking the other side of your trade – the seller – is betting that you are wrong.  You can’t both be right.  One of you is going to win, and one of you is going to lose.  Before you buy a stock, you should ask yourself “why is someone willing to sell this stock at this price?”  If the person who is taking the other side of  your trade has done their homework more thoroughly than you, they may know something that you don’t.  As part of our coaching, we’ll teach you how to make a checklist of the questions you should ask yourself before you pull the trigger on any trade.  This is part of the discipline that you will have to have, if you want to compete successfully in the game of investing.
  2. There are no do-overs.  When  you make a mistake and lose money, you can never get it back.  This is because of the existence of the Game Clock.  You only have a finite amount of  time to accumulate your winnings, and once your time is up (you need to start spending your winnings in retirement), your time is up.  For this reason, it’s critical that you learn to minimize your mistakes, and learn from them so you won’t repeat them.
  3. There is no such thing as a stock-picking Guru.  Many investors mistakenly believe that there are highly skilled professionals out there who know how to pick winning stocks consistently.  They figure it’s just a matter of time before they find their personal Guru.  This is not correct.  Stock market Gurus are regular people who are usually smart, hard-working, and extremely lucky.  They achieved the status of Guru because they had a serial run of luck with their picks, and eventually their luck will run out.  This always happens.  Always.  So you need to ask yourself, when is this particular Guru’s lucky streak going to end?  Will I be the last guy to follow his advice just before he crashes and burns?  Beware of the investment Guru, because he doesn’t exist.  It’s better to learn how to pick your own stocks, so you don’t have to rely on someone else for your success.
  4. Don’t put all your eggs in the same basket.  The most common mistake investors make is putting too much of their money into stocks when the market is going up, and then yanking it all out after the market has gone down.  Successful investors have learned that they should always have a balance between stocks, bonds, and cash.  That way they don’t have to panic and sell their stocks when the market takes a tumble.

The Players

Would you walk into the poker room in a Las Vegas casino and play against professional card sharks?  Would you step onto a football field and play against a professional team?  The answer is yes, but only if you have the right skills, ability, and training.  It’s the same when it comes to investing.  You are competing against the best minds and the biggest bankrolls in the world, and unless you know exactly what you’re doing, you will probably get eaten alive.

One way we can divide the players is between the “smart money” and the “dumb money.”  This has very little to do with intelligence or education.  It has a lot to do with preparation and experience.  The smart money is the class of investors who are well informed, usually have lots of capital behind them, and are well connected to the best sources of information.  The dumb money are the folks who are flying by the seat of their pants, hoping that the stock tip they got from their broker, the newsletter they subscribe to, or the guy at the water cooler, will pan out.  The dumb money is what’s called a “low-information” investor.  We’ll teach you how to avoid being the dumb money.

Correct Strategy

There is a right way and a wrong way to invest.  The correct strategy starts with a well-written investment plan, and a discipline to carry it out.  Every time you buy or sell a stock, it should be done within the context of your plan.  For example, you may have decided to put 60% of your money into stocks.  Let’s say that one of the stocks you own announces bad news, and you decide to sell it.  The correct strategy would be to not only sell your stock, but to immediately replace it with another stock that you’ve been keeping an eye on.  That way you will maintain the same 60% allocation to stocks.  There are many other examples of correct strategy, and we’ll teach you all of them.

When To Cash Out

Of all the possible mistakes that investors make, I think the most common, and the most costly, is cashing out too soon.  Most inexperienced investors hang on to their losing stocks for far too long, and then they sell when they just can’t stand the pain any longer.  At that point, the price of the stock is usually near the bottom.  Then, to compound the problem, they wait until the stock has rebounded in price, and by the time they get over the pain of their loss, the price of the stock is near the top of the range.  This is commonly called the ” buy high, sell low” strategy, and it’s undoubtedly the biggest reason that most investors never achieve their true potential.  We’ll teach you how to know when it’s the right time to cash out, and it won’t be based on emotion.  We base our buy and sell decisions on pre-determined rules, so that these decisions are based on reason rather than fear and panic.

If you want to learn how to play the game at the same level of competitiveness as the professionals, become a Premium member of zeninvestor.org and start your training today.

A Short Primer On Risk

Understanding Risk Is Important

Risk is one of the most difficult concepts for amateur investors to master (I use amateur not in a pejorative sense, but as compared to professional investors.)  Part of the reason for this is that investment risk is often counter-intuitive.  Take treasury bonds for example.  Treasury bonds are often described as “riskless” investments.  The theory is that the U.S. government is unlikely to default on its obligation to bondholders, and therefore your money is always safe in treasury bonds because they’re backed by the full faith and credit of the USA.  This statement is true, but it doesn’t necessarily follow that investing in treasury bonds is free from risk.  Treasury bonds trade on the open market, and the prices of treasury bonds fluctuate, just as the prices of stocks fluctuate.  If you invest in treasury bonds at a time when interest rates are historically low, you are in fact exposing yourself to above-average risk.

Bond lovers will counter with the argument that if you hold your treasury bond until it matures, you are guaranteed to receive 100% of the face value of the bond, and therefore they are truly riskless.  My answer to this argument is that very few investors actually buy treasury bonds with the intention of holding them to maturity.  Most investors sell their bonds before they mature, and this exposes them to the risk of selling them for less than their purchase price.  The point is that all investments, including so-called ‘riskless’ treasury bonds, have risk.  You simply can’t escape the fact that nobody can predict with absolute certainty what an investment will be worth when it comes time to sell.

How Much Risk Are You Taking?

Many investors use what I call an Ad Hoc Stock Picking approach.  What I mean by this is that they wait until they ‘feel good’ about their economic circumstances, and then they start picking stocks based on a combination of tips, recommendations, and hunches from all kinds of sources.  It’s called Ad Hoc because there is no unifying theme or context for their choices.  They end up with a collection of stocks that may or may not be appropriate for their circumstances.  And by not considering the prospects for growth in the economy, they risk being too heavily concentrated in stocks at the wrong time.  We advocate a balanced approach to stock picking, which dramatically reduces overall risk while not sacrificing the fun and excitement of ‘playing’ the stockmarket.

Types of Risk

There are two main types of investment risk.  The first is the risk that the market price of the investment will decline and the investor will take a loss at the time of the sale.  The second type of risk is the loss of purchasing power.  Inflation averages about 4% per year over the long term.  If your investment produces a rate of return that is less than the inflation rate, which is often the case with ‘safe’ investments like treasury bonds, then you will find yourself in a situation where you made a profit on your investment but lost purchasing  power.  Would you be satisfied with that outcome?

The Answer

In order to manage these dual risks – price risk and purchasing power risk – an investor has to create an investment portfolio that includes components that will provide some protection against both market downturns and inflation surges.  The only way to do this is with a balanced approach that includes many different types of assets, like stocks, bonds, real estate, gold, hedge funds, private equity, volatility, and others.  The more asset classes you have in your portfolio, the less overall risk you take.  Risk is not a bad thing.  In fact, it’s because of risk that investors are rewarded with returns that are higher than the rate of inflation.  If you have a well-diversified portfolio, you should be seeking risk, not running from it.  Risk is the source of superior investment returns.  But risk must be properly understood, and managed.  Ad Hoc investing ignores this calculation of risk, and because of this, returns are usually disappointing.

The Truth Is Out There

The Seven Noble Truths Of Investing

1. Knowing who you are (as an investor) is important.  If you don’t know who you are, the stock market is an expensive place to find out.  The smart way to go about investing is to first figure out who you are, and then come up with a plan that fits you.  For example, some investors are hyper-sensitive to market declines.  But other investors have a long-term perspective about the market and don’t get upset when it goes down.  If you’re hyper-sensitive to declines, you might sell your stocks too quickly, when the correct strategy might be to hold on, or even add to your holdings.

2. Taking the time to sit down and write an investment plan is the single most important thing you will ever do as an investor.  The second most important thing is reviewing your plan regularly, and making the adjustments that are necessary.

3. Having the right balance in your portfolio is much more important to your long term success than picking good stocks.  Balance accounts for 95% of your results, while stock selection accounts for just 5%.

4. The most powerful force in finance is tax-deferred compounding.  The second most  powerful force is time itself.  Unless you are maximizing both of these concepts, you are giving money away and you will never get it back.

5. If your personal wealth is growing at less than 10% per year, you have a problem with your investment plan.  The biggest causes of leakage are costs and panic selling.  Both of these should be addressed in your written plan.

6. The source of your advice is just as important as the advice itself.  This is because most investment professionals have financial incentives to steer you in a particular direction – the one where they make the most money.  This isn’t illegal, or even immoral.  It’s just the way the business works.  It’s important to develop advice and information sources that are truly independent, and therefore are free to speak the truth.

7. Amateur investors think in terms of what’s possible.  Professional investors think in terms of what’s probable.  It’s possible that you will find the next Microsoft and become fabulously wealthy, but it’s not probable.  It’s both possible and probable that you can grow your personal wealth at a steady 10% annual rate if you stick to a well-written investment plan.

To learn more about these truths, or for help with your investment plan, visit my website at www.zeninvestor.org

Don’t Fight The Tape

How do you explain the behavior of the stock market today? In an environment where almost every piece of news is bad, how is it that the market was able to rally so convincingly? One possible answer can be found in the sage advice of Benjamin Graham – one of the few true gurus of investing. Graham once remarked that “in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine (i.e. its true value will in the long run be reflected in its stock price).”

What this means in the context of today’s market action is that investors have voted, and in the short term the bulls have won. The debt ceiling will be raised, the European banks will not disintegrate, and the current earnings season will not bring any nasty surprises.

But in the long term, the market will weigh the evidence and perhaps reach a different conclusion. The lesson to be learned from this is that betting against the momentum of this rally can be hazardous to your portfolio. Our model portfolios remain fully invested in stocks, and as uncomfortable as this may be, we remain steadfast in our commitment.

How Bias In Fiancial Advice Can Hurt You

Bias is sneaky. Most of us don’t even know it’s there. The advice we get from our broker, our planner, or our favorite website seems logical, straightforward, and honest. But, lurking just beneath the surface of the well-crafted copy (words organized to convey a point of view) lies a silent killer of performance… bias.

It can take many forms. It can be a hidden agenda. It can be a conflict of interest. Or it can simply be an argument based on a false premise. Whatever the nature of bias, the impact is the same – it leads you to make investing decisions that could end up costing you a ton of money.

Today I’ll focus on one of the most common forms of bias out there. The asset-gathering bias. Brokers, advisors, and planners are all in the business of gathering assets. Fees are based on assets, so these folks all want to capture as many accounts as possible, and bigger accounts are always better. There’s nothing sinister or evil about this fact of life. People need to get paid. But when it comes to your money, this bias is more than dangerous. It’s a killer.

Has your broker/advisor/planner ever called you up and told you to sell everything and go to cash? I didn’t think so. That would be career suicide for a financial professional. They don’t want to scare their clients, they want to calm them. So most professionals do a lot of ‘hand-holding’ when things get dicey in the market. But is this really in your best interest?

Here’s the shameless plug for a skilled investing coach. I have nothing to gain by keeping my clients invested in the market. If I think that the odds favor a big market drop, I’ll tell my clients. If they move to cash, it doesn’t affect how much money I make. But it reinforces their faith in my commitment to always tell it like I see it.

I’ve been coaching for more than 30 years, and my clients expect me to tell them the truth, even if it’s scary. Since I always do that, and I never pull punches, my clients are fiercely loyal to me. By simply avoiding the stock market when a major recession is coming, my clients make about 4% more per year in returns on their portfolios. That means average annual returns of 13% to 14% for the majority of my clients. It’s no wonder they’re a happy lot.

For details about how to become a client, check out my website at http://www.zeninvestor.org.