Editor’s note: This article was first published in December 2012, months after ECB President Mario Draghi’s July 2012 ‘whatever it takes’ speech; its remark that tech companies of the day might end up as a bubble reflects that time.
Everyone who invests in the stock market is looking for the same thing: that foolproof method that always wins and never loses. In other words, the perfect investment method or system. On the face of it, achieving this would be as simple as picking rising stocks, ideally in rising markets, and never holding on to a falling stock, avoiding sharp corrections or bear markets at all costs. Put like that it sounds very simple, yet in reality very few people have managed it.
Is the perfect investment method long-term investing, medium-term, short-term or trading? To reach this utopia, should we give more weight to technical analysis, to company fundamentals or to macroeconomics? Should we diversify widely or only as much as necessary?
To begin with, we won’t say that the stock market is a game (although lately it might look like one), but it is clearly a competition between people. It is you against the market, and the market is, on one side, a group of people like you and, on the other, a very small group of people or institutions who call the shots. Once you know the rules of the game, your competitors and your enemies, you will know what you are up against. Make no mistake: you are playing in a manipulated market, where a few people decide what the market will do tomorrow. Let’s call these people the market keepers (we all know they exist), although I call them the market manipulators.
For this simple reason, 95% of retail traders lose money and the other 5% make money, but about the same amount they would have made with long-term investing or trend trading, with fewer headaches. We’ll explain these points now.
So we won’t find the gold mine we are looking for in trading. But what about the long term? Is investing for the long term more profitable?
If we look back at history, the best investment method known so far has been that of Benjamin Graham and Warren Buffett, among others we have already mentioned as the best investors in history. There are other names, such as Joel Greenblatt or Peter Lynch.
All these investors had something in common: they all based their investment strategy on the long term and on company fundamentals. In fact, Benjamin Graham dismissed “chartists”, or technical analysts, as useless, and called anyone who invested on the strength of technical analysts’ reports sheep. He didn’t believe in charts, because a chart really forms a rising or falling trend according to the company’s fundamentals. THERE IS NO COMPANY THAT HAS GONE BANKRUPT AND CURRENTLY HAS A RISING CHART (obviously).
At the other extreme, of course, we have George Soros, a living example of how to make 1,000 million in a few days through pure speculation. Mr Soros became the model for speculation schools where thousands of “would-be speculators” lose their shirts because they forget that they are small fish in a sea full of sharks.
The thing is, if we remember what Benjamin Graham wrote in his book “The Intelligent Investor”, he used to say that in a bull market you are more likely to buy shares above their real value, and so your chances of losing increase. By contrast, when you buy shares in a bear market, you are more likely to buy them below their target value, and so your chances of winning increase.
These words later gave rise to Warren Buffett’s famous line: “Be fearful when others are greedy and greedy when others are fearful“, or in other words, buy when everyone is selling and sell when everyone is buying.
“If the market has fallen, buy, and if it falls further, take the chance to buy more. In the long run you will win.” This thinking holds as long as you have chosen a solid company, the kind Warren Buffett recommends.
Mind you, we are talking about an investment method that gave Graham an average annual return of 17% for more than 30 years, and with that return he became one of the best investors in history.
What if we combine Graham’s method with trend trading?
Let’s rule out intraday trading completely. We can, however, use trend trading, where we pick a stock that has been beaten down too far over several sessions, or one whose price has fallen after doubts appeared in the market over several days.
At that point we can enter the market and even use leverage to make the most of that short upward trend in one or more stocks.
Trend trading means riding a stock through its trend, which can be up or down and last days or weeks. That is why it is highly advisable to keep part of our capital in cash to take advantage of very specific investment opportunities, such as the day of Mario Draghi’s magic words.
There are days when the market is waiting for news that will cause either a crash or a big rally, and on those few days alone we can beat half of Graham’s annual return and, depending on the stock, double it.
However, if you open and close positions on the stock market every day, it is almost certain that by the end of the month or the year you will be losing money or making the same as you would have made in the long term.
Avoid bubbles or take advantage of them?
If we go back to the sayings of the great investors, “when your hairdresser buys shares, sell yours”. While it is true that bubbles appear cyclically, as the dot-com bubble did and as will probably happen with many of today’s tech companies, these great investors would not advise jumping on those trains, because nobody can place these companies’ business models in the future.
It is said that in 1998 analysts made a point of ridiculing investors who didn’t invest in internet stocks: “Look at those fools… the returns they’re missing out on.” When the bubble burst, the fools were the ones who lost the capital they had invested. But make no mistake: there were also plenty of smart people who got in and rode the bubble knowing it was a bubble, and so, after making 20%, 30% or 1,800%, they took their profits and got out before the ship sank, while still holding their usual shares in solid companies.
So what is the perfect investment method?
Without a doubt, it is buying, in a market that has just fallen, into a solid company, ideally one with good dividends and the ability to keep paying them whatever happens. It should still have growth potential and a product that competitors can’t easily displace.
We will always go in with a long-term mindset, taking advantage of falls to increase our position by buying more shares. But if we want to add a masterly touch to our method, then if at some point any news about the company appears that could raise doubts and send the stock tumbling, don’t wait until you have lost 20%. Get out of the stock and buy back in with the same amount or more, picking up the shares much cheaper once the steep falls are over.
Never sit on a 50% loss in a stock because, as I always say, Buffett and Graham’s method is all very well, but we don’t have Buffett’s capital.
If we add that return lies in risk, we can, once in a while, try to take advantage of specific short-term opportunities, without falling into the mistake many investors make: in trying to build up capital quickly, they end up losing it just as quickly.
As for diversification, I’ll borrow an expression from the great investors: “Excessive diversification is a way of protecting yourself against ignorance.” Choose a maximum of 4 to 8 stocks, and before you think about buying a new one, ask yourself whether it would be better to increase your investment in the stocks you already own.
Further reading
- 10 mistakes to avoid when investing
- The most profitable time of year to invest
- Which investments are most profitable for reaching financial freedom
Featured image: Niccolò Caranti, CC BY-SA 3.0, via Wikimedia Commons.
