Improving Your Decisions
What if I told you I had a trick that could help you make better decisions, not just with stocks, but with everything in life? Okay, maybe it’s a pretty obvious thing, but it’s surprising how few people actually do it. Are you ready for the big secret? Here it is… think things through before you make your decisions. "That’s stupid," you say, "everyone thinks about things before they make their decision." True, you may think about things, but do you really quantify your reasoning behind each choice?
How do you "really quantify your reasoning" though? The easiest way is to write a blog! I’ve said before that I would post on my blog even if nobody read it, and I actually mean it. It doesn’t matter how well you write or what you end up saying. The important thing is that you have to think about what to write. Just trying to jot down a few sentences about a stock you like can be a very enlightening experience. There have been numerous times that I liked a stock, sat down to write about it, and then realized that I really didn’t like it so much when I had to rationalize it in a public forum.
It also works for things beyond just stocks. Thinking about leaving your wife for the stripper down the street? Go write that blog post first and see if you can come up with a solid appraisal of the situation. If you end up with a well thought out 10,000 word post that backs your decision to leave, at least you know you’re making a conscious decision to do it. Chances are though, once you sit down and are forced to formalize your arguments you’ll realize it’s a stupid thing and you would probably be embarrassed to have any of your reasons read by everyone you know.
I also have a selfish reason for this tip. I have a lot of friends who are very smart and know a lot about stocks, and I want to be able to see what they’re thinking too. But even if you don’t want to make a public blog, a private journal can also do the trick. You’ll be amazed at how much your opinion can change the first few times you try it. And this doesn’t even go into the benefits of having a historical record of your thoughts, but that’s what I’ll be talking about next time. So set forth, start your blog, and make sure you give me the address.
Downside Of Short ETFs
Yesterday I mentioned one way to size short ETF positions to hedge a portfolio. So if you can do just as well without putting up as much cash, why would anyone not go for these things all the time? Well, there’s a lot that goes on behind the scenes with these guys. Short ETFs just attempt to match the daily move of the underlying index by fudging their positions on a daily basis. Since it’s an ETF that’s very actively managed, there are a lot of fees that go along with it.
Also, since it’s just matching the daily movements of the index, over the long run that doesn’t quite work out due to compounding. Say you started both funds at $100, one which is a double short of the other. If the index goes up 1%, the double short goes down 2%. After the first day, the index would be $101 and the ETF would be $98. If the same thing happened a second day, the index would be $102.01 and the ETF would be $96.04. Now let’s say the index goes back to $100 on a 1.97% drop; the ETF would go up 3.94% and end up at $99.82. That’s minor right now, but over the long run it will end up not tracking the index as tightly as you may be hoping for.
While not a disaster, it helps to understand why the S&P500 may go down 30% but SDS only goes up 50%. Ideally, if you truly want two times the short exposure to an index, you would play the index futures or options so that you can manage your long term exposure a little more finely, but of course those have a whole other can of worms that go along with them. Your 401k probably doesn’t have that option though, so knock yourself out with the short ETFs and watch your portfolio at least stay afloat while everyone else is eating it.
Hedging With Leverage
If SDS isn’t enough for you, there are actually triple short (and triple long) ETFs out there. I didn’t mention when they opened up at the beginning of the month, since I use options when I want that much movement, but someone asked about them so I figured I should comment. One way to use these things is to decrease your position size and put the rest of the money towards something safer.
For example, if I had $10k that I was putting into SH (1x short), I would instead put $5k into SDS (2x short) + $5k into a safe investment, or $3.3k into BGZ (3x short) + $6.7k into the safe investment. The numbers today show that the results of the ETF parts would have been SH +5.78% (+$578), SDS +11.22% (+$561), or BGZ +16.98% (+$565). Depending upon how lucrative the "safe" part is, it could be a good idea to have other investments while still hedging the same amount. Note, SH and SDS are S&P 500 ETFs while BGZ is a Russell 1000 ETF triple short, but this was just a general idea of how to split your money and why these aren’t just for the crazies.
Go With the Flow
After a big event, like a basketball game or a concert, there’s always a flood of people rushing out to the parking lots. Sometimes there’s a quicker, backdoor way to get out, but if you’re too far downstream it’s pretty much impossible for you to get there. Even though you know it’s better, it would be futile to attempt it, so your only options are to follow the masses slowly meandering out the main door, or wait for it to clear out a little before heading for your unknown shortcut.
I constantly bring up the point that you should be trading with momentum, rather than against it, and this is exactly why. Think about what actually makes stocks move. While good earnings and balance sheets make a stock worth more intrinsically, that does not necessarily make the stock price go up. What does drive the price up is people wanting to buy more shares than are currently being sold.
Maybe you noticed an underlying company that is good, but the majority of the people are going the other direction and selling. People sell their shares of stock for a variety of reasons, and if you’re reading this blog you probably aren’t in a position where your buying a stock against the trend would make a significant number reconsider. If the large majority of the people are going against it and making the stock go down, the only options you should consider are shorting it or better yet, if it really is a good company, stand on the side until they clear out. Who knows, maybe the thousands of people going in what you think is the wrong direction actually do know better. Standing on the sidelines and waiting may not be exciting, but attempting to go against the crowd will just leave you trampled and broke.
Hitting the Bottom
In down markets I’ll often say to wait for the market trend to reverse before entering any new long positions. I can’t say enough that you shouldn’t try to catch a falling knife, and patience in crashing markets is the key to your financial survival. I’ve talked about looking for trends and reversals before, so here’s a supplemental piece that expands on spotting market-wide bottoms.
Whenever the market is crashing, there will be days that plunge hard, followed by strong bounces. In order to not drive yourself crazy following all the volatility, you should be looking at weekly charts of your favorite index. Looking at daily charts will just give you too many false bottom signals and the stock market in general doesn’t move that quickly. Look at some index charts like the S&P 500 over the past 50 years and you’ll notice that the trends last for years, not just weeks or months.
Now that you’re looking at the right charts, start looking for some support (and I don’t mean a jockstrap). When the surges downward stop making new lows, they’ll often form a double or triple bottom. This is one of the strongest chart patterns out there for stocks, and when it breaks out on the market level you can make a whole lot of money.
Above is the chart for the recession at the turn of the century. You can see that the market hit the bottom in 2002 and then took months before it really took off again. If you look at any other market crashes, like in 1987, you’ll see similar bottoming action. Of course in 1987, the crash occurred over an extremely compressed amount of time, but once at the bottom you’ll see the same sluggish recovery. I don’t think a diving market has ever stopped on a dime and changed directions to form a V bottom.
A lot of people get scared that they’re going to miss out on the big gains so they try to time the bottoms. Or maybe they just like buying lots of stocks for "value" because they enjoy telling people that they caught AAPL at the very bottom. Of course they always fail to include that they bought into GOOG, FSLR, and DRYS along the way for 50% more too. Just relax though, you’ll still have plenty of time even if you’re late to recognize the reversal. The cost of guessing wrong the other way is much more expensive.
Ignoring Share Price
Often times newbies lose interest when they see a stock with a high share price because they like owning more shares of a cheaper stock. I can’t count the number of times I’ve heard someone comment about how a $200/share stock is too expensive for them, but a $10/share stock is in their price range. They’re probably thinking that if they own 1000 shares of XYZ instead of just 10 shares of ABC, they’ll be able to make 100 times more money. But would you rather have 10 shares of BRKA (currently trading at $140,000/share) or 1000 shares of STEM (currently trading at $1/share)?
Does a stock with a high share price have less potential for growth though? At one point, BRKA was less than $75. As it passed $100 some people probably thought it was expensive (this was in the 1970′s). As it passed $200 the next year, even more people probably started to think that. Passing $400 a couple years later must have been ridiculous at the time, but going over $1000 a few years later is insane, even by today’s standards. I could do this all the way up to $140,000 a share in 2008, but I think you get the point.
Looking at things like how much a stock earns per share (aka the EPS) and market cap are much more important in determining if a stock is "cheap" or "expensive" than the share price. If you have x shares at a stock price of y, your total value of the position is x times y and it doesn’t matter what the values of x and y are individually. The thing that matters is the total value and how much percentage is gained or lost overall.