Dear stock investor,
If you are new to stock investing, you are likely to experience one or all of the three struggles below:
Being tempted to take profit on a winning stock because you don’t want to lose your gains when it starts going down.
Being tempted to move money around by selling stock A to buy stock B because you have limited investment money, and stock B appears to be doing better than stock A.
Being tempted to sell all your stocks because the market appears to be in a downturn
In the past two weeks since my last post, several people have reached out to me asking if they should sell their stocks and take profits because of COVID-19. Some others are asking if they should wait until there’s a definite solution to the COVID-19 pandemic before they start buying stocks.
Nobody knows for sure how the market will fare post-COVID-19, but I am confident that we will recover over the long term.
However, the easiest way to lose money when investing in stocks is to make investment decisions from a trader’s point of view.
Understand the game you are playing
Traders and investors are playing totally different games with the same ball and on the same pitch.
For traders, a minute, an hour, a day, or a week is often enough time to exploit the price and momentum opportunities for profit in the stock market. Traders can buy a stock at $X and sell it at $Y within the next hour without recourse to the intrinsic value of the underlying business.
Problems arise when investors who are playing a game with a longer timeframe allow their actions to be dictated by the actions of traders playing a game with a shorter timeframe. And in my experience, a desire for a short cut to wealth combined with the right amount of social persuasion can cause people to make illogical decisions.
The one major difference between trading and investing
Stock trading (you can also include forex and crypto trading) is a zero-sum game. Someone has to lose money for you to make money, and the net change from a wealth or benefit standpoint is zero - but this is not the problem.
The problem is that you are playing a game against professionals who spent years learning how the stock market works. You are playing against amateurs traders who have spent years understanding the stock market. You are playing against AI-powered systems of high-frequency traders who can place thousands of trades between when you blink and strike the "enter" key on your computer.
Unless you have a large trading capital, and the professional expertise, or years of experience, you’ll most likely end up with net losses as a stock trader over the long term.
Conversely, stock investing is a positive-sum game. With stock investing, once you pick the right stocks and are willing to wait, everybody can make money because the size of the pie somehow gets bigger over time.
Deconstructing why the prices of stocks rise and fall
In the last two weeks, the U.S. stock market has delivered an exhilarating uptrend and a slightly disappointing downtrend. Between May 1 and May 15, the S&P 500 (a representative index of the broad U.S. stock market) gained 4.76% even though it initially climbed 6.83%, declined by about 2%, and then recovered by almost 1%.
On May 8, the U.S. Bureau of Labor Statistics reported that employment fell by 20.5 million in April and that the unemployment rate rose to 14.7%
This was simply bad news - it suggests that the road to a post-COVID-19 recovery for the U.S. economy and indeed the rest of the world is long and uncertain
Based on the bad news, the stock market should have tanked; yet, the market continued on its rally without reacting to the obviously bad economic news
Now, this is where it gets interesting.
Some professional/experienced traders most likely figured out that the market was at a high on May 11 and they decided to take their profits off the table.
Once those big players started exiting/reducing their positions, the sell-side (supply) of stocks became more than the buy-side (demand) for stocks. And since the supply was more than the demand, the price of stocks started falling.
Once the prices of stocks started falling, the fears of a sell-off turned the decline into a self-fulfilling prophecy. Investors who were previously worried about keeping their profits were manipulated into panicking and selling their stocks.
However, as soon as the price of stocks falls to a certain point, those big traders started buying stocks again and the buy-side (demand) side became more than the sell-side (supply) side.
And again in response to demand and supply, the price of stocks will start recovering until the cycle is repeated.
The hardest thing to do is NOTHING
The trading price of a stock is reflective of what market participants think a share of the underlying business is worth. Now, the determination of what the share of a business is worth is both empirical and sentimental.
If the underlying business has a great product, operates in a growing market, has a strong competitive advantage, a solid management team, and low debt; you can logically expect that the market determination of the share price to continue increasing. For investors, these are the factors that should determine whether you buy, hold, or sell a stock.
However, traders don’t really care about these fundamental factors. Traders mostly care about how a business decision, news, a sociopolitical or economic event will disrupt the demand and supply dynamics, and to find ways to profit from that change - and that’s okay if you know what you are doing.
However, if you want to be a successful stock investor, it is important to understand that short-term volatility is inevitable.
Traders won’t stop playing their games and changes in the demand and supply dynamics will always cause the price of stocks to rise and fall.
However, if you are convinced that you have picked the right stocks based on the right business fundamentals, you can be sure that the general direction of what a share of that business is worth is northbound, and that your slice of the pie will get bigger as the whole pie continues to grow.
If you have the right stocks in your portfolio, you shouldn’t worry too much about short-term volatility, time is your ally, and there’s no reason to dash in and out of stocks unless there’s a significant shift in the business fundamentals.
The main point here is that investors should develop the mental fortitude to do nothing in response to short-term volatility, stay the course, and avoid making investment decisions based on the actions of traders who are playing a totally different game.
Here’s wishing you success on your investment journey
I was planning to write about Healthcare, Biotech, and Life Sciences Stocks to Watch Amid COVID-19 but the prevailing market conditions influenced me to write about the psychology of investing instead.
Next week, I’ll write about the healthcare stocks that are likely to emerge as winners in a post-COVID-19 world.
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