Content provided by Rusty Vanneman, CFA, CMT, Chief Investment Officer
Years ago, I worked with bond and currency traders around the world (mostly in New York City, Chicago, and London), providing trading recommendations and market commentary every 20 minutes during market hours. The work environment was fast-paced, fun, and absolutely awesome in terms of being totally immersed in the markets. I learned a ton and made many friends that I still have today.
But, that frenetic approach to the markets is nothing like how I invest these days, professionally or personally (which both are basically the same). It’s also not how I recommend anybody invests. It’s simply too crazy and demands too much time, emotion, and expense. It’s a tough game to play, and particularly so for any duration. There aren’t many old traders.
(To be clear on definitions, I define trading as an inherently short-term activity. One may hold a position for only days, or as short a time period as minutes or even seconds. Investing meanwhile, is a long-term activity, measured in years, if not decades).
Nonetheless, there were many valuable principles I learned that influence how I think about the markets today. Here are three market maxims, and why I think they’re important:
- “Let your winners run, and cut your losers short.”
This is probably one of the most important keys to successful trading or investing.
For starters, many investors simply hold on to their losing positions too long, letting them get much deeper in the process. They might be emotionally attached to the position. Or, they have too much pride. Or, they don’t want to be wrong. In some cases, substantial losses result, often sabotaging overall portfolio returns. There is no reason this should happen in a taxable account. One could simply harvest tax losses to offset future realized gains. If the positions are held in non-taxable accounts, there should still be a disciplined process in place that will help investors get out of losing positions. Stop losses, regular reviews, or checklists are three tools that could be used.
Losses are not the only problem. Many investors like to realize gains in winning positions too quickly. From an emotional standpoint, it’s often satisfying to take the gain. It’s a win! Money in the bank. But, most successful investors attain success from their long-held positions. The big winners have an outsized impact on their overall portfolio success.
2. “The market moves in the direction that causes the most pain.” Or, on a related note: “What is comfortable is rarely profitable.”
Consensus thinking is wrong so often on Wall Street, it is amazing people continue to invest in what they think is “safe” by investing in what is popular. In my experience, the market moves in the direction most don’t expect — the direction that causes the most pain.
This actually makes sense. When there is an imbalance of emotion in a particular investment and investors are positioned accordingly, expectations make the investment become vulnerable to a reversal.
For instance, if most investors think a particular technology company will continue to grow at a spectacular earnings growth rate (let’s say 50% for example, which would be a supremely high expectation since the average company has pulled in earnings growth closer to 6% over the last 90+ years), they may bid up the company’s stock price and valuation. So, what happens when the growth rate is actually 50%? Perhaps not much. It was already priced into the stock price. Now, what if the growth rate is only 40%? That is still spectacular growth, but it’s below the stock’s expectations and what valuations warrant, so it’s probably a poor result for those who own the stock. And, what if earnings growth falls toward the long-term average — like all companies ultimately do? Not good.
3. “The train has left the station.”
This saying is a favorite of mine. It may not be as popular as the maxims above, but it captures a key principle behind many successful investments. And, quite frankly, it’s fun to say.
As it relates to investing, this saying refers to a situation where a particular asset class hasn’t gone anywhere in a while (it’s at the station), but has finally started to move and is likely ready to embark on a major trip. Many relative, value-oriented managers, such as CLS Investments, like to buy assets that have underperformed recently and are now undervalued and priced for relatively superior returns moving forward. Once the market starts to reverse the prior underperformance and appears to potentially (hopefully) have a long run of good performance ahead, then “the train has left the station”.
A good example, particularly in recent quarters, is emerging markets. After lagging for many years, emerging market stocks have started to outperform handily. We hope the train left the station for emerging markets last year and the sector has a long journey still to go.
The trading experience in the early years of my career helped me learn many techniques of successful (and not so successful) trading and investing and helped inform and shape my decision-making process. The maxims above are three of the most impactful I’ve learned thus far. Stay tuned for more in future blogs!