Oh my god, my stock is falling…. SELL!
Fear and greed, the two great nemesis of the market. This is probably the MOST important part of trading for the inexperienced and experienced trader alike.
If you golf, this is the same as “keep your head down.” Easy to say, nearly impossible to do. Have you ever sold a stock only to see it go up the next day? I have, too many times to mention, FEAR. Have you ever, for seemingly no good reason, bought stocks on a whim just because it’s going up and you are afraid of missing the train? GREED.
GREED: greed, like love, creates a chemical rush in our brains that eliminates common sense and self-control. You watch the market going up, you are afraid of “missing the party” and so you just jump in and buy anything and everything. Why? Just because.
Remember the “.com” boom of the late 1990s? Investors rushed to buy everything internet related. Investors were greedy and the greed made securities jump to grossly overpriced levels, creating a bubble. Well, it burst in mid-2000 depressing the market through 2001.
Alan Greenspan called investor greed, the “irrational exuberance” of the overall market. During the dotcom boom Warren Buffett was criticized for not investing in high-flying tech stocks. But when the bubble burst he was proven right. He stayed with his comfort zone and followed his plan.
FEAR: a stressful state giving you a sense of impending doom. The stocks you just bought out of greed are falling. Now what do you do? You SELL.
When stocks fall for a sustained period of time, we become fearful of sustaining further losses. When the dotcom bubble burst, investors were awash in fear. Investors quickly moved out of the stock market in search of safer ground.
Money moved into money market securities, value funds and other low-risk and low-return securities. The sad part of this is that while it stopped the bleeding, these low-return instruments guaranteed no chance of ever rebuilding the lost wealth.
Greed and fear are the emotions that consistently make us do the opposite of what we know we should do: buy low, sell high. Greed makes us buy high and fear makes us sell low. So what can we do?
We must understand the market because once you understand how something works you can begin to temper your enemies – fear and greed.
The Fear Cycle
Let’s take a real world example. In 2008 and 2009 stocks were falling and the housing bubble had burst. Two large brokerage firms, Lehman Brothers and Bear Stearns were nearly destroyed. People didn’t want to buy stocks. This is the fear cycle.
By 2013 the market was improving, the rate of unemployment was slowing and housing starts were up. People began to believe that things were getting better. This is the hope part of the cycle. In 2014 the talking heads on TV were declaring a bull market. People wanted to get in before it was too late. The same people that sold low were now buying high. This is the greed part of the cycle.
To make money in the market you need to do the exact opposite that most amateur investors do. When the market has a dip, buy. When the market goes up, stay with it. When the price of the stock reaches levels out of proportion to its intrinsic value, sell.
The Secret To Success
What does Warren Buffett say about fear and greed? “Be fearful when others are greedy, be greedy when others are fearful”.
If you want to be a successful trader you must learn to control your emotions. Like the golf game, you take practice swings (paper trading) and they are fantastic. Then you step up to the ball, get into position, and begin your backswing – you over swing, power it down too fast, and lift your head – managing a slice into a nearby home.
As the market explodes to never ending heights the greedy amateur buys more and more. Buffett sits this market out. It’s really time to be fearful.
Now the market begins the inevitable pullback. You just bought at the peak and you are seeing red. What do you do? While you are selling, Buffett is doing the opposite. He takes the cash he saved while you were greedy and begins buying low.
Three Steps To Harness Your Fear And Greed:
Understanding The Stock Market
- The stock market is an adversarial system. Every time someone sells a stock (“I know it’s going down”) there is another trader buying (“I know it’s going up”). Both cannot be correct.
- Why stocks go up and down? If there are more buyers than sellers stock prices go up. Conversely, if there are more sellers than buyers the price goes down.
- Why is it difficult to predict the market? As Forrest Gump so amply stated, “Shit Happens.” The media, the opinions of well-known investors, natural disasters, political and social unrest, risk, supply and demand, and countless other unforeseen events all play a role in the markets behavior.
- There are numerous books and articles you can read that explain both fundamental and technical aspects of the market. But think of this. If you wanted to learn how to fly a plane, would you just read a book and hop behind the controls? Can you read a book, watch a video or two and perform surgery? Probably not. So why would you risk your nest egg without training?
Have A Trading Plan And Follow It
“Fail to plan and you plan to fail.” Ask any trader who makes money on a consistent basis and they will tell you, “You have two choices: you can either methodically follow a written plan, or fail.”
A good trading plan helps remove the insecurity and doubt which leads to greed and fear. Fear to enter a trade. Fear that the stock will turn and eliminate your small profit, making you sell prematurely. A trading plan also helps eliminate greed that gets you into trades you never should have entered.
Every instructor in the financial world will encourage you to spend the time necessary to develop a trading plan. Can you imagine the pilot of your airplane flying without one? Why should you? The components of a trading plan include:
- Skill Assessment – Are you ready to trade? Have you done paper trading? Can you follow your plan without hesitation?
- Mental Preparation – How do you feel? Are you emotionally and psychologically ready to do battle in the markets. Don’t trade angry, hungover, or after a fight with your significant other.
- Risk level – Make sure you know your money management. How much are you willing to lose on any single day?
- Goals – Set realistic profit targets and risk/reward ratios.
- Research – You need to know your stocks and what influences them. Be prepared to spend time every week studying the current environment that can influence your stocks.
- Trade preparation – Get your ritual down pat. What do you do every morning or weekly before beginning your trading?
- Have exit rules – Do you know when you will sell the stock? Most of us spend all our time seeking the perfect indicator, guru or other signal for buying a stock. Don’t be afraid to take a loss if the trade no longer makes sense. Don’t “hope” it will turn around. Also, don’t get greedy and lose earned profits while hoping for more.
- Have entry rules – Exits are much more important than entries, but know when you will enter. I have seen experts that can pretty much enter any stock, at any time, and in any direction. But they know how and when to exit. Make a simple system to enter. Don’t complicate it with several rules and conditions.
- Keep records – Records allow you to see what works and what doesn’t.
As a physician I hate saying this, but physicians are the worst traders in the world. Do you know who the best are? Pilots. A physician is always in charge and infallible. He knows what’s right and doesn’t need anyone telling him how to do it. Pilots, well they are great at following instructions. They generate a plan and follow it. No matter what.
This obviously goes without saying. The more you do something the more comfortable you are doing it.
When you first started driving you were nervous. You had to look at everything around you. You second guessed yourself. After some experience you can almost drive automatically.
Experience teaches you that the market is always going up and down. You learn that a dip is an opportunity to buy cheap, not something to fear and sell. Experience teaches you that if you can’t buy a stock at the price you want, don’t buy. Like a railroad station, there is always another train coming. Don’t let greed get you into trades you shouldn’t be in.
CNN maintains a Fear & Greed Index (money.cnn.com/data/fear-and-greed/) which takes the general pulse of the market. Using seven different indicators of the market in general they calculate the current emotion of the market, which at the time of this writing was GREED.
That’s it. Take the time and learn to manage these demons of the trading world and you will be well on your way to becoming a successful trader.
James Krider, MD
Krider Wealth Management