While I was out for the Passover holiday, I received a very interesting email from a reader at Seeking Alpha. While I often receive many emails, and simply do not have time to respond to them, especially since they are often looking for very specific investment advice, I think this one deserves a response since it applies to all those who are new to the investing world.
It also gave me an idea for a new series of articles on Seeking Alpha along the lines of the old "Dear Abby" articles, and if there is enough of an interest, I may begin a series entitled "Dear Avi," which would be devoted to more basic questions about the markets.
So, here we go.
"Dear Avi" question:
I wanted to ask you, how did you come to acquire the knowledge you have about the markets? Right now, I'm torn b/w all the information available out there (I receive over 100 emails a day from SA authors alone that I follow...all with their own methods/techniques, analysis, and opinions. I have also looked into technical analysis, option markets analysis, fundamental analysis...it's so overwhelming (and I have subscribed to services for all of these, but don't know what to focus on)! What would be the best strategy going forward? What should I focus my attention on learning? Would learning fundamental analysis and financial modeling be worthwhile? What about any books, resources? I'm 28 years old, and late to investing. I feel so far behind the curve...could you help out a confused wanna-be investor? :) Thanks for all your help!
Well, James, understand that at 28, you are not late to the game. But, you should begin your learning now so that you can put your learning to work as you grow older and your income increases.
As for me, I learned about markets the hard way, as they say. When I began my investing career, like many, I devoured everything I could possibly read and get my hands on. I figured that if I was able to develop an "expert" level of knowledge on a particular market or sector, then I would be able to outperform the rest of the market. So, being a lawyer and an accountant, as well as a voracious reader, I set about my task with great fervor and zeal.
Sadly, the more I read and learned, the less I was able to outperform the market. It often left me scratching my head when a stock or market moved in the exact opposite direction dictated by the fundamentals I was reading.
And, for some reason, I was comforted when I heard an analyst on television state that "the market is just not trading based upon fundamentals at this time." While the "red" was clearly evident in my trading account, at least I was not stupid or wrong. Or, so I thought. For some reason, hearing those words made me feel better even though the losses were still mounting. It was somehow acceptable to have losses in my account, since I "knew" the market was wrong, rather than my analysis.
Well, it did not take much more in the way of mounting losses to eventually come to the realization that I was simply part of the herd, and the herd will never recognize a trend change before it happens. Rather, they are simply "herded" to the slaughter.
As an average, everyday "Joe," I had to come to the realization that fundamental analysis was not going to give me an edge over the rest of the market. I recognized that not only was the market not trading based upon fundamentals at a particular time, but that fundamentals are really not what drive markets at all, rather, they lag the market. Ultimately, my search led me down a path of understanding market sentiment, which made a lot more sense as a driver of markets as compared to the lagging fundamentals I had been studying.
After my revelation, I became much more proficient in analyzing many markets and stocks based upon sentiment, and started developing a following within the trading sites to which I subscribed over the years. But, almost 6 years ago, I began providing public market calls and analysis of precious metals through Seeking Alpha, which only focused on fundamental perspectives. So, I was faced with a conundrum. I wrote to the editors, and explained to them that, while I would love to provide my analysis, I do not believe in using fundamentals to track a market. We came to an understanding that I would discuss market sentiment as my "fundamental" perspective in analyzing the metals market.
I quickly became the number 1 metals analyst, and held that spot for the next 3 years for which I wrote for them.
But, that is my story. Let's now focus on you.
As far as how you should approach the markets, my own opinion would be to begin with basic books about the stock market just so that you can understand some of the basics, such as what is a stock, ETF, ETN, option, EPS, etc. I would also suggest you learn about how investors use leverage, because once you understand it, it should bring you to an understanding as to why novice investors MUST stay away from leverage, as that is how most new investors/traders blow up their accounts. This also is a strong warning to stay away from leveraged ETFs, about which I have warned many times over the past 5 years.
Next, you should learn about risk management. In my humble opinion, before you even make your first trade/investment, you MUST have a risk management plan in place. You see, there is not a single investor alive that has ever put money into a trade or investment expecting to lose any money. Everyone is quite certain that they are going to make a killing each and every time they put their money to work. And, since everyone is so certain about the killing they are about to make in the market, they never consider the downside of the trade/investment they enter. So, when the market moves against them, they simply sit in their position, and "hope."
"Hope" is a four letter word that can kill any investment account. So, rather than maintaining an investment based upon "hope," if a trade moves against you in a manner in which you did not expect, it is much better for you to exit that position, and then place the money in a position that has much more immediate potential. And, you must set the parameters for exiting the trade BEFORE you even enter the trade. In other words, for each and every position you enter, you must have a plan for when you will enter, when you will "stop out" if the trade goes against you, and when you will take your profits. As Ben Franklin said, "by failing to prepare, you are preparing to fail." So, each and every time you put your money to work, you MUST have a plan as to how you handle a losing trade, as well as a winning trade. Remember, if you stay in a winning trade too long, it can also turn into a losing trade.
The next piece of advice that I highly suggest is that you learn about market psychology. This has two factors to it. The first is learning about the psychology of a trader/investor so that you can better understand the feelings you may have at any given point in time during your investment/trade time frame. You will feel fear, impatience, disgust, joy, euphoria, etc., and you must know how to control those feelings in order to avoid making emotional decisions. That is why having a plan made before you invest your money (and following it) is so important because it helps take out the emotion from your immediate decision making. The plan you create when you are not in an emotional state has already made those decisions for you.
The second factor is learning about the psychology of the market in general. While there are many clichés I can cite right now, the one that probably best explains markets is bears make money, bulls make money, but pigs get slaughtered. Effectively, this means that one should not be a pig at a market extreme. But, you will have to learn about market sentiment in order for you to understand when to be a bear, when to be a bull, and how you can avoid being a pig at a market extreme.
Another issue with which you will have to grapple is how you choose your investments. Some people invest in companies that interest them. Others invest simply based upon the companies' charts. My suggestion to you is if you are investing in very large cap stocks, you must have an understanding of the technical charts of those companies as they are driven more by mass sentiment than fundamentals, with prime examples like Amazon (NASDAQ:AMZN) or Tesla (NASDAQ:TSLA). But, if you want to invest in very small cap companies, like small biotech companies, then you had better understand the nuts and bolts of the company before you put your money to work. Personally, I stay away from smaller companies because it is much easier, more reliable, and often safer over the long run to invest in larger cap companies, and they are much more predictable.
Lastly, remember that MOST of what you read in the blog-o-sphere or from financial analysts is going to be wrong at the most important time. Yes, I said it. But, it is true. You see, I have come across so many studies that prove that market analysts herd just like all other investors, and are always caught on the wrong side of a major market turn.
As an example, in 1996, Robert Olson published a study in the Financial Analysts Journal in which he studied the effects of herding upon "expert" fundamental analysts' predictions of corporate earnings. After studying 4000 corporate earnings estimates, he arrived at the following conclusion:
Experts' earnings predictions exhibit positive bias and disappointing accuracy. These shortcomings are usually attributed to some combination of incomplete knowledge, incompetence, and/or misrepresentation.
Mr. Olson's article suggests that "the human desire for consensus leads to herding behavior among earnings forecasters," with the herd always looking for the current trend to continue unabated and indefinitely.
James, while there is certainly an overload of information out there, I would suggest you take it one step at a time, and not be in a rush to put your money to work until you have an understanding of the issues I have presented above. There is also nothing wrong with "paper trading" until you have learned all of what I have outlined above, but just remember that when you have your money on the line, and emotions take over, you need to know what you are doing and have it planned out well in advance so that you do not get caught within the overall market fear or euphoria that can destroy your account.
While I use Elliott Wave analysis to analyze market sentiment, one of my long-time and quite astute members once pronounced:
The goal of EW analysis is to analyze sentiment, not participate in it!
In summary, I want to go over the steps I believe you need to learn before putting your hard earned money to work so that you can rise above the herd and not participate in the herd when it is being led to slaughter:
1 - Learn the basics of the market, along with all the basic market terms
2 - Stay away from leverage
3 - Learn about "risk management"
4 - Have a plan for each investment you make and FOLLOW IT
5 - Learn about market psychology
6 - Be discerning as to whom you will listen for "expert" advise
James, I wish you luck in your long-term endeavors.
Questions by readers
As I said in the opening to this article, if this is something of interest to those that follow me on Seeking Alpha, then feel free to place your general questions in the comment section below. If there is sufficient interest in this idea, then I may try to continue this series, and pick a question or two every week to address in an article. Also, if I see that there are a number of readers with similar questions, then that is clearly something upon which I can focus in my next article in this series. Let me know what you think.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.