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Never Tell The Markets What It Should Do

The most important lesson I've learned in my 10-year trading career is this: Do not tell the market what it's supposed to do; instead, let the market tell you what it is going to do. It's easier said than done. Most people put their ego and convictions ahead of prudent risk management, investment flexibility and a true assessment of market conditions. To quote John Powell at MSN Money's Money Blog:

"So you can call it whatever you want - a "bear market rally", "short covering rally" or whatever else. But in reality, market moves like the most recent one should instead be used as an important learning opportunity. They teach all investors who put their convictions ahead of prudent risk management a simple lesson- concentrated bets on the binary outcome (example- 100% bull or bear market positioning) could sometime earn you a "genius trader of the moment" spot on the CNBC, but they can also just as easily put you out of business, if you turned out to be betting on the wrong outcome.

As this WSJ article shows, quite a few hedge funds that have done reasonably well in the past, have been caught completely off guard by market's astonishing 50% recovery from March low and some even have been shutting down. Many of these "economic skeptics" have either been increasing their cash allocations or even boldly increasing their bearish bets as the markets first plunged and then started to recover earlier this year."

It is not bad to have your own convictions. In fact, it is important to have your own assessment of things given the amount of noise percolating in financial media and the analyst community. You still need to develop your own analysis to segregate actionable ideas from noise. However, "humility" is the one aspect that traders and investors alike have deep issues with.

For a lot of people, it's more important to be right than to recognize what is really happening around them. People are addicted to making predictions, thus telling the market what to do. They don't realize that they are just individuals with subjective opinions (which can be right or wrong) within a market wherein many other (contrary) opinions still count. And its not just opinions on fundamentals, there are other factors like liquidity, supply and demand, fund performance benchmarks, regulation landscape, as well as interrelation of asset classes and global markets or something that can even be totally irrational, which can affect any given stock market. The moves that are demonstrated by the stock market are real until it moves the opposite direction. Opinions are, on the other hand, relative. You can't be ahead of the market, it's always ahead of you. Otherwise, it can be attributed to luck (and the next time you might not be so lucky). It's listening to all these factors that is the difference between outperformance and underperformance. It's better to lose a little pride and be wrong from time to time, than risk losing everything for the sake of being right.

This is the problem with the hedge fund industry where the professionals are managing other people's money. They don't care if so much money is wasted in stubborn bets, it's not their personal wealth that's being wiped out anyway. All that matters is that they have the chance to be proven the top dog if they turn out to be right. In the very end, it all comes down to being an ego thing.

When the market moves the opposite direction of your predictions and that move is sustained, people can stay stubborn all they want. But take note of this, the stock market is the biggest ego-buster of all, and can dish out an unlimited serving of "humility". In many cases, being flexible is more profitable than being right.