[B]INVEST?
TRADE?
GAMBLE?[/B]
A
newcomer to the market faces three paths that lead into a forest full of treasures and dangers. The first path, for investors, goes through the sunniest areas. Most of those who take it come out alive, if not much richer. Another path, for traders, leads into the heart of the forest. Many travelers disappear, but those who come out look rich. The third is a shortcut that takes gamblers into the swamp.
How can you tell which path is which? You must choose your way carefully because if you don’t, you’ll end up on the gamblers’ path, especially since it crosses both investors’ and traders’ trails. We’ll return to this question in the chapters on trading psychology.
[U][B]AN INTELLIGENT INVESTOR[/B][/U]
Investors profit by recognizing new trends in the economy and buying into them before the majority wakes up to opportunities. A knowledgeable investor can earn huge percentage gains by holding his position without being terribly active.
Back in the 1970s, I bought stock in a company called KinderCare, which ran a chain of child care centers. It tried to make them as uniform and reliable as McDonalds’ hamburgers. KinderCare catered to baby boomers who were having babies right, left, and center. Half of my friends were pregnant at that time. A major social shift was taking place in the United States, with women going to work in record numbers. Someone had to mind the babies of all those two-income families, and the stock of KinderCare soared on the crest of a new social trend.
AT&T used to have a monopoly on long-distance phone calls. Then in the late 1970s a tiny brash upstart called MCI won a legal dogfight, 7
allowing it to compete with AT&T. The age of deregulation was upon us, and the stock of MCI—the first company into the breach—sold for $3 presenting another great opportunity to hop aboard a new trend.
A few years ago I flew into New York from the Caribbean with my friend George. He became a millionaire by buying $30,000 worth of Dell stock before most people had heard of the company—and unloading it at the top three years later with the help of technical analysis. Sprawled in his first-class seat, George was perusing several investment advisories, trying to lock in on the next trend in Internet technology. How right he was! Within a year Internet stocks were flying, defying gravity.
That’s the lure of investing. If you can buy a chunk of Dell at $4 a share and cash out at $80 a few years later, it is easy to fly down to a resort for a week rather than sit in front of a monitor watching every tick.
What are the disadvantages? Investing requires a great deal of patience and an immense supply of self-confidence. To buy Chrysler after it was rescued from the brink of bankruptcy or Internet search engines before anyone knew what those words meant, you had to have a huge level of confidence in your ability to read the trends in society and the economy. All of us are smart after the fact; very few are smart early in the game, and only the tiniest percentage has the emotional strength to make a large bet on their vision and hold on to it. Those who can do this consistently, like Warren Buffett or Peter Lynch, are hailed as superstars.
[U][B]AN INTELLIGENT TRADER[/B][/U]
Traders make money by betting on short-term price swings. The idea is to buy when our reading of the market tells us prices are rising and sell when the uptrend runs out of steam. Alternatively, we can bet on a decline and sell short when our analysis points to a downtrend, covering when the downtrend starts bottoming out. The concept is simple, but implementing it is difficult.
It is hard to become a good analyst, but harder to become a good trader. Beginners often assume they can make money because they’re smart, computer-literate and have a record of success in business. You can get a fast computer and even buy a backtested system from a vendor, but putting money on it is like trying to sit on a three-legged stool with two legs missing. The two other factors are psychology and money management.
Balancing your mind is just as important as analyzing markets. Your personality influences your perceptions, making it a key aspect of your success or failure. Managing money in your trading account is essential for surviving the inevitable drawdowns and prospering in the long run. Psychology, market analysis, and money management—you have to master all three to become a success.
There are two main approaches to profiting from crowd behavior. The first is momentum trading—buy when a ripple starts running through the crowd, sending the market higher, and sell when that ripple starts losing speed. It is a challenge to identify a new trend while it’s still young. As the trend speeds up and the crowd becomes exuberant, amateurs fall in love with their positions. Professionals remain calm and monitor the trend’s speed. As soon as they find that the crowd is returning to its normal sleepiness, they take profits without waiting for a reversal.
The other method is the countertrend strategy. It involves betting against the deviations and for a return to normalcy. Countertrend traders sell short when an upside breakout starts running out of speed and cover when a downtrend starts petering out. Beginners love to trade against trends (“let’s buy, this market can’t go any lower!”), but most get impaled on a price spike that fails to reverse. A man who likes peeing against the wind has no right to complain about his cleaning bills. Professionals can trade against trends only because they are ready to run at the first sign of trouble. Before you bet on a reversal, be sure your exit strategy and money management are fine-tuned.
Momentum traders and countertrend traders capitalize on two opposite aspects of crowd behavior. Before you put on a trade, be sure to know whether you’re investing, momentum trading, or countertrend trading. Once you’ve entered a trade, manage it as planned! Don’t change your tactics in the midst of a trade because then you’ll contribute to the winners’ welfare fund.
Amateurs keep thinking what trades to get into, while professionals spend just as much time figuring out their exits. They also focus on money management, calculating what size positions they can afford under current market conditions, whether to pyramid, when to take partial profits, and so on. They also spend a great deal of time keeping good records of their trades.