Investing Ideas

Nothing Always Works, but Here Are 3 Market Truths (Tradecraft)

via SmartMoney.com by letters@smartmoney.com (Jonathan Hoenig) on 7/5/09

Three Market Truths

Even after trading for more than a decade, I still haven't figured out any market maneuver that always results in a guaranteed profit. From "Don't Fight the Fed" to the January Effect, markets are littered with a long list of "surefire" tips that don't always turn out.

It's a reality lost on many new investors looking for a quick score. Simply put, nothing "always works." When inefficiency develops in a competitive and open marketplace, opportunistic investors are quick to capitalize. This is what makes markets function.

So I don't know of an asset class, a time period, an investment style or an approach that always mints money. And if I did, I certainly wouldn't write about it online.

Turns out the truisms that always work have less to do with the markets than with the technique we use to approach them. This is congruent with our overall philosophy at Tradecraft -- that it's how you trade that has a much bigger impact on your results than what you trade. What follows are three market truths that speak to the importance of solid technique.

1. The shorter the time horizon, the more difficult it is to make money.

There's a fantasy, especially among new traders, that markets function as some sort of ATM machine to which you can roll up and make a withdrawal whenever the feeling strikes you. In reality, the shorter the time horizon, the more difficult it is to make money. That's why so many day traders fail miserably after even a few weeks time.

Traders in such an immense hurry forget the biggest wins come from buying and holding over a sustained move, not trading an investment away the minute it shows a gain.

2. Winning trades usually start out as winning trades.

Another truism holds that, more often than not, winning trades are profitable right from the start. Of course, it doesn't mean XYZ never goes a point against us, but that winning investments have a tendency to show a profit — even a modest one — within the first few days after having taken the position.

Where traders often fall off the track is that they take a position and hold on, even as it falls sharply below their initial purchase price. Of course, because of the mathematics involved, they end up digging themselves a hole out of which it's nearly impossible to climb. For Citigroup (C) to get back to the levels it was at two years ago, the stock needs to climb some 1,600%.

3. Avoid buying stocks solely because they are cheap or boast good dividends.

Finally, experienced investors know to avoid buying a stock or fund solely for cosmetic reasons — namely, because it's either low-priced or has an attractive dividend. Low-priced stocks, as we've covered in this space before, are the lottery ticket of the market world, albeit probably with worse odds. With a small handful of exceptions, low-priced stocks are low priced for a reason — and it's not because they're poised to make a miraculous comeback. Penny stocks, the pink-sheet-listed companies that trade for a few cents a share, should be avoided altogether.

Similarly, don't be fooled into buying a stock simply because of an attractive dividend, a common error, especially among older investors looking for income. The problem with picking a stock solely for the dividend is that not only can it be cut at the company's whim, but that the payout always ends up paling in comparison to the price action of the security itself. Just witness the performance of San Juan Basin Royalty Trust (SJT) or Provident Energy Trust (PVX): Even double-digit dividends couldn't help overcome the losses from holding shares as they fell with energy prices. Same goes for high-yielding REITs. Even a 10% dividend yields means nothing when the stock falls 25%.