The first rule of investing is buy low and sell high. After all, that's the only way you can actually make any money in the market. Nearly all investors would agree with that idea. But there's another group of market participants that are trying to do the exact same thing - they're just trying to do it in a different time frame and with a different methodology. They're called traders. Generally speaking, investors tend to scoff at traders. However, wise investors may want to take a closer look at some things that traders do well. In this article, we'll give you a rundown of some of the skills that traders use that investors would do well to emulate.
You Only Make Money if Your Stocks Go Up
Most investment advisors would say that a well-performing company is the key to a successful investment. Unfortunately, that's not entirely true. As an investor, you only make money if your stocks go higher, and there are many instances in which great company fundamentals don't benefit investors at all. Take Frisch's Restaurants as an example. Between the end of fiscal 2003 and the end of fiscal 2005, annual earnings improved from $1.95 per share to $2.82 per share. However, between the company's 2003 and 2005 earnings reports, the stock dropped from $28.25 to $21.04. In other words, the company did very well, but shareholders did not. Could it be that the stock was just too expensive at the end of fiscal 2003? Not likely. The price-earnings ratio (P/E) then was 13.08, and by the end of 2005, the P/E was 11.82. Frisch's put up some great numbers, but shareholders suffered anyway.
Most investors would have loved to find a stock like Frisch's in late 2003, but the average trader would have noticed something simple that signaled a problem with the stock. Namely, Frisch's shares had fallen under the 50-day moving average at the time earnings were released, and had made a clear bearish reversal pattern over the two weeks prior to that. In retrospect, any investor would have appreciated a trader's ability to recognize that this particular stock was likely headed lower.
SEE: Simple Moving Averages Make Trends Stand Out
Moving averages are one of the most basic tools used by traders. If a stock is under many or all of the key moving averages (20-, 50-, 100-, 200- and 250-day moving averages), then that stock is probably headed lower - regardless of what the fundamentals look like. There's an old Wall Street saying that cautions, "Don't buy stocks, buy companies." Investors tend to buy companies, while traders tend to buy stocks. However, the very best investors soon realize that both components are required in order to achieve top results. Before you make an investment, it's worth a look to see if it's actually moving in the right direction, or if it's above most of its moving averages.
Technical Analysis Isn't Bad if It's Done Right
Technical analysis, behavioral analysis, chart watching or voodoo - call it what you want. At some point, most traditional investment advisors have poked fun at this approach. In some cases, the ribbing is deserved. There are plenty of technical analysts who have promised untold fortunes based on their trading systems, and then failed to deliver.
SEE: Introduction To Types Of Trading: Technical Traders
The fact of the matter is that there is no secret chart-watching technique that is guaranteed to generate wealth. Once an investor recognizes this fact, he or she can start to use technical analysis properly - as a tool to help weigh the odds of a stock taking a particular course over a certain time frame. At the very least, every investor should be aware of what kinds of return enhancements proper chart analysis can provide.
For starters, charts and market timing can provide an edge on entries and exits. For example, in 2005, the S&P 500 gained a net of only 3%, but the total movement of this large-cap index was actually much higher. Take a look at the major up and down trends of the S&P 500 for that year:
January 1 to 21: Down 3.8%
January 21 to March 4: Up 4.6%
March 4 to April 15: Down 7.0%
April 15 to July 22: Up 7.4%
July 22 to October 21: Down 4.5%
October 21 to December 31: Up 5.8%
As you can see, the total travel of the S&P 500 in 2005, both up and down, was 33.1%. Even if you're a long-only investor, the total 'up' travel was 17.8%. Is it realistic to think that any investor could have known where the exact bottoms and tops were? No, not at all, but even if a basic index investor had only stayed in for half of the three downtrends, the total 2005 return would have been bumped up to 10.1%. Is that realistically achievable for the average investor? Yes, it is. In all three instances of major downtrends, the S&P 500 fell below its 100-day moving average about halfway through the bearish period. Using that exit signal alone would have turned a benign year into a relatively productive one. The flipside, of course, is getting back into the market when stocks are at a short-term bottom and starting to move upward again, but similar moving average tools can be applied to bullish trends as well as bearish ones. The point is that technical analysis can indeed help an investor time an entry or an exit.
The one caveat for investors is this: don't get bogged down by daily charts or short-term moving averages. Weekly charts are less erratic and, therefore, easier to interpret. Monthly charts may seem completely unhelpful, but they're not. They can indicate stock trends in the same time frame in which you're thinking when you first buy equity.
Emotions and Egos Can't Be Part of the Equation
One of the key edges that traders have over investors is that they don't take things personally. Traders know the market is a game of odds. For many traders, it's not unusual for half of their trades or more to be losing ones - and yet, they still make money. That 50/50 ratio is a whole lot of negative feedback if a trader assumes that individual trade success is a reflection of personal intelligence or stock-picking prowess. Fortunately, it's not. The fact of the matter is that picking a loser in no way indicates a lack of intelligence or savvy. It's just a case of a stock that defies the odds. If you play good odds often enough, you'll eventually win, even if one trade doesn't work out.
SEE: Losing To Win
What most investors may not realize is that the same success results and ratios are typical of buy-and-hold portfolios, despite the fact that their stock picks are based on thorough research and solid logic. The problem is, logic can't be applied where logic doesn't prevail. Sometimes stock prices make sense, but many times they don't. There's more than enough fear and greed involved in the investing game to prevent logic and reason from working all the time. Traders don't need sound logic to be profitable; they just need to know when a stock is rising or falling.
If an investor uses sound logic to buy a stock and the stock sinks anyway, that same investor is apt to internalize the idea that he or she is inadequate as a stock-picker. Or worse, that investor is apt to hold onto a loser, allowing ego to convince him or her that the decision was the right one and it just needs more time. It's what many call the "it'll come back" syndrome. It's also a dangerous habit that investors need to unlearn, like most traders already have.
The Bottom Line
Traders and investors are treated like night and day when, in fact, both types of market participants are trying to accomplish the same goal. However, by incorporating some of the best practices of top traders, investors can greatly improve portfolio returns.
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