Getting the Basics Right When Investing

Investing Basics

Those who promote conventional approaches to investing are constantly trying to school us on it, but the most important part of learning is being willing to ask the right questions.

There has been a movement afoot ever since we got the ability to trade ourselves on the internet. It wasn’t really that long ago when electronic trading was limited to the professionals, on intranets, with the rest of us having to place our trades over the phone or in person because we did not have access to electronic trading.

Before that, it was actually done all on paper, back when people would get their trading information from the stock section of their newspapers or on the ticker at their brokerage. We could consider this the dark ages of investing, and it only got brighter than this over the last few decades, although the sun is now fully out and we need to embrace its light if we are to put ourselves in the best position to succeed.

The big changes have come in trading, and while buying and selling securities all involve what we call trades, a trade to enter where you buy a certain amount if you are on the long side and another to close your position, being a trader rather than being considered an investor have to do not with the average time that you hold your position, but how attenuated you are toward your positions.

This is a misconception that it is critical to get over if we are going to be learning how to invest better, because unless we do, we will be stuck with ideas such as traders who only hold positions for much briefer periods than we intend to have nothing to do with us and there isn’t a requirement for us to pay attention to our positions the way they do, because we are in for the longer haul and don’t need to care.

That’s a view that is terribly wrong actually, and what ends up separating us is the level of diligence that we pursue, with traders requiring a much higher level of diligence to the degree that they use leverage, where the importance of managing risk becomes higher in proportion to the greater risks they take on, but this does not mean that diligence can simply be ignored as investors like to pretend that they can.

We spend a lot of time seeking to educate our readers who consider themselves investors, and it is all from the perspective of pointing them toward higher levels of diligence, where we do not just read the leaflet and follow along like children but actually are willing to think about what we are trying to do with our investing and how well we accomplish it, to constantly seek out a better way.

As traders, we approach investing from this perspective, but the perspective of trading is not about time frames, it is about how we approach what we do, to seek to align the optimization of our goals with our actions. While people can do well over time being completely ignorant, the more aware we are, the better we will do, and every investor should choose to do better.

The principles that we will be discussing in this article are all simple ones, but are necessary to consider whether we are intend to be in our trades for mere seconds, or several decades hopefully, or anything in between. This all really just comes down to knowing what we are looking to do and then coming up with a plan that best fits it.

We are not intending to teach you how to trade, although these basic principles are the foundation of all trading, regardless of how long positions are held. All good trading principles apply equally to whether you are using one second bars or one year bars, whether you are trading price action purely or trading the mood on the street, although everything we use must ultimately fit the price data or we will be out of touch with what is actually going on.

The last year has provided a great opportunity for investors to wake up more to the realities of what moves stocks, to understand that it is the movement of price that matters, and nothing else, even the biggest of other things, and we’ve had some pretty big ones over this time. If we are looking at the wrong things, we are already lost and are left to hope that fate smiles on us.

This is how people generally approach investing, to see prices rise over time and just jump on board, without even any sort of plan at all other than to hope that fate continues to be kind. They are told that they cannot help themselves and to turn their money over either to index funds or active management by others, and while the latter may seem like a better way, it isn’t if those we entrust to manage our financial futures can’t even beat random baskets of investments.

Breaking free of this intellectual prison requires that we start with the absolute basics, what our goals are with investing. This does not mean setting goals for returns and such, as this puts the horse before the cart, focusing on what we wish to see as far as results are concerned without even feeling the need to examine the process and what might lead us better results. We need to stop hoping and start examining if we expect to help ourselves.

There are two goals involved in any investing or trading, which is to seek to both drive return and manage risk sufficiently. Putting half your money in stocks, an index fund perhaps, without managing their risks, and then the other half in bonds where you aren’t paying attention to risk either but may have less downside isn’t the right way to do this, or anything close, as popular as this may be.

The average investor, or almost all investors as it turns out, will claim that they do not have the knowledge or experience to make any decisions at all, and while that may be true, they don’t realize that choosing to be ignorant is a decision as well, and the worst one that they could be making as it turns out.

The most basic principle of successful investing is therefore to take ownership of our results, not just pretend it’s not us deciding when we decide to hand this over to someone else or to do nothing other than hope. Investing is a game of playing probabilities, and even the best decisions can leave us disappointed at times, but we always want to do our best to get probabilities on our side, not ignore them, and this is the only way we can be assured that we are seeking the best results we are able to.

Make no mistake, investing is a game of skill, and the more skill that is employed, the skill to play the probabilities well, the better we will do. People differ greatly in terms of the amount of skill that they bring, as well as their commitment to improve their skills, but we all need to be aware of the significance of this and at least be aware of the ways we can be helping ourselves.

Some are incapable or unwilling to manage their own investments at all, and may instead choose predetermined baskets of stocks like index funds, or even invest in actively managed funds, but this is at best delegating authority, not absolving yourself of it. We are the captains of our own ships, even though others may be hired to run it, and when we refuse to provide oversight, there is no one left to make sure that it is on the right course to take us where we want it to go.

We Are Always the Ones That Ultimately Decide Which Path to Take

This oversight that we have, this responsibility for the guidance of our investment plans that we have whether we choose to admit it or not, is the first key lesson that we can learn from traders. Traders control their ships all on their own, where their skills at navigate will determine their degrees of success or failure, so it’s easy for them to understand their role in this, as captain, although with investors, it is not so easy.

Investors may choose to go with an index fund, and then turn the engine off and let their ship float aimlessly on the water, allowing the weather to take it wherever it wants to. They need to realize that it is they who have chosen to float around aimlessly, and then compare the decision to do this with other more active decisions on how to navigate, where even the most modest ability can represent at least a better attempt to chart a good course than no attempt at all.

This is the point of failure with investors generally, where they are told that trying to pilot their ships is a dangerous practice that cannot be used to help themselves and will just get them into trouble, and they just believe. Trading requires active management by its very definition, where investing can be performed without any at all, where just closing your eyes and watching the waves is an option if we wish, and this is what the great majority of investors do wish, because they are too afraid to get involved at all.

All securities trading requires timing, and like we try to pretend that doing nothing isn’t a decision, we also pretend that not timing our investments does not involve decisions about timing. Holding positions until we die is a form of timing them, and choosing an infinitely long time frame is still choosing a time frame.

The rap against timing investments is that these decisions have consequences, such as getting out of a good investment foregoes further gains should it keep going our way without us. The same is true if we choose to hold on to investments as they go against us, and we make choices about this every day whether the choice is to continue on or leave, and both impact results.

This is our second basic principle of investing, with the first being that we are ultimately responsible for our overall guidance whether we choose to realize it or not, and this second fundamental principle being that we are constantly directing our investments whether we realize this or not, as both action and inaction both involve investing decisions.

When we pretend otherwise, we end up missing the fundamental fact that whatever path we choose exposes us to risk, and a primary goal of our taking an active role is to seek to avoid having our ship being blown the wrong way and especially avoiding the rocks, in other words to reduce risk, not pretend it doesn’t exist and bear it blindly.

There is no approach that takes on more risk with a given investment than to choose not to manage risk at all, and even though we may end up being too defensive, running from every little risk when we should be focused on the bigger ones, this may miss out on return, but it does serve to limit our risk, too much in this particular case.

If, for instance, you use a strategy which has you out of your positions with a rolling stop loss of 5%, when they dip this little and you are out, and don’t get back in until you move beyond this, this may not be such a great way to proceed if you are investing as it will give up this 5% each time this happens and will impact your returns in a strong bull market, you have capped your risk at this 5%, where just sitting back and watching takes on the entire risk, following the bears down to wherever they wish to take us.

Among its tasks, timing positions attempts to optimize return, which may or may not be successful depending on how well you do this, but since this involves stepping aside when the risk is perceived to be too high, the very practice involves seeking to manage risk, and it is ridiculous to think that avoiding managing risk manages it somehow.

The idea of just holding positions because you are risk averse is a pretty foolish one, and realizing this is the third basic principle of successful investing. Like Goldilocks, we do not want too much risk management, or not enough, but need to prefer a level that is in between, just the right amount. We may not end up choosing the right amount exactly, as this requires some real skill and understanding, but realizing that we need to try is the first step.

The fourth basic principle is realizing that we do direct the level of returns that we seek, and this has to do with not only being in the right investments to best achieve returns, it also means that we need to be in the right investments at the right times, where we are obligated to assess both the risks and the returns of our investments on an ongoing basis if we wish to direct ourselves toward success properly.

We might correctly believe, for instance, that a certain stock has a great long-term outlook, and that we expect to realize a good return in 10 or 20 years, which may be the period of time that we are concerned about. Investments zig and zag to various degrees along the way though, and where we go between then and now may matter a lot, and may also indicate that our original guidance was not correct and this may have looked like a good investment when we bought it but may have changed.

Watching the path of our investments and ensuring that they are on the correct one, and that we are only in them when the probability of success is high enough in both the shorter and longer term, is only part of this. We need to ensure that our eyes remain open to whether there may be better opportunities out there that may deliver an even better risk to reward ratio for us, and this is the part that investors mess up the most with.

This is how investors can justify putting a big chunk of their money in bonds, and the other part in stock investments that simply do not measure up competitively. We might choose a modest approach that delivers 6% return with our stocks on average and then dilute that with even less competitive returns from bonds, where we may instead have achieved results several times better without taking on any more risk, or even with less risk if we know a little about what we are doing.

Managing risk on the basic level that investors need to isn’t that difficult at all, but it does require a little thinking at least. Seeking returns always comes down to comparisons, strategies both within holding them, being in when the probable return is high enough and also being in the investments where they are high enough, but managing risk adds an element of threshold to the mix.

To show the threshold part, let’s say you just retired and have a certain amount saved up for it, which may not be enough but at least will help you avoid serious discomfort. You decide to put all of your money into an option way out of the money, that has a 1% chance of paying out but this will increase your portfolio beyond what you could ever have hoped for. You dream of travelling the world, but the burden of being left broke in retirement is simply too much to bear.

The potential return is enormous but the risk involved is also enormous, and no one in their right mind would attempt such a thing, putting their life savings on the line with such a bet, and anyone can appreciate just how brutally wrong this is. The reason why this isn’t a neutral proposition is due to the principle of diminishing marginal utility, where the first dollar we have is the most valuable and their value declines as we add more.

We do not need to be working these things out mathematically like an economist would, as common sense is enough, although we do need to make sure we are using common sense, and good sense is not so common when it comes to the way people manage their portfolios.

Seeing Our Plan in Action

Let’s look at our stock example of half your money in the S&P 500 and half in bonds to see how this all comes together. This is a completely hands-off strategy, or it at least appears to be to the great many investors who choose such an approach or something similar, but we will apply our four basic principles of investing to see how far off the mark this might be. We’ll call this approach A by investor A and then look at what approach B which investor B uses might look like in comparison, the one that uses these basic principles we are sharing here.

The first principle, our taking responsibility for the oversight and results of our investing strategies, has investor A plenty comfortable enough regardless of what happens, wherever this ship aimlessly sails to, because he does not see himself as even a participant. Investor B realizes that he is the captain here and doing nothing is one choice among many, and understands that it’s better to justify our choices here than pretend that we aren’t making any. When investor B stands pat, it is from an informed perspective, not an ignorant one.

As their ships rise and fall with the waves and the weather, investor A just proceeds on, torpedoes or anything else be damned. He is deluded into thinking that this does not involve timing his investments, and while every day requires a timing decision, to stay or to leave, but apparently not if you can successfully pretend that nothing is being decided along the way.

Investor B, realizing that we are always timing our investments, our second basic principle, will actually pay attention to whether it’s better to stay or leave when the storms come, or the lure of another part of the sea where the weather is better generally is worth setting sail for instead.

Investor B also realizes that gazing on the horizon looking for changes in the weather is not something you do once and forget, as the skies may be clear when you start your journey with an investment but these things can change. Just sticking with these two investments like investor A has chosen ignores opportunities, where a better course may be indicated and choosing to stay the current course in the face of evidence that this is no longer a good idea isn’t avoiding timing, it is exercising bad timing.

Investor A has chosen to set up this bond position because he has refused to time his index fund investments and somehow thinks that having two boats floating around aimlessly is somehow better than one. Investor B has no issues with investing in bonds, provided that the time is right, when stocks are actually dropping and bonds are producing a positive return, which requires that we seek to time our positions with both, not neither.

This leads into our third principle, managing risk. Investor A actually thinks that setting up this dual strategy manages risk, over just exposing his entire portfolio to this stock index fund, and some risk management may at least seem better than none at all.

Even this isn’t true though, although with managing risk, even if an approach were a little better, this does not mean that there aren’t even better ones. It is not enough to choose just any risk management strategy, we need to choose good ones, comparatively, and this is managing risk somewhat but does so terribly.

The risk that the bonds are designed to manage are only situational ones though, and investor A does not understand the role that higher returns play in risk management, and this certainly not a lesson we want to be ignorant toward, as this by itself does more to harm investor A than anything else.

We just need some very simple math to understand this. If we have two competing investments, stocks and bonds, and we see stocks pull back by a third like it did for a time last year, we don’t want to be patting ourselves on the back when we see that we have diluted this drawdown by half, only “losing” 17% instead of 34% if we had it all in stocks and just sat by and watched the carnage as we choose to do.

Investor A stuck his tongue out at investor B at this point, but investor B pointed out that just by sticking with stocks over time, he got several times the rate of return than A did, and this greater return has provided a buffer so he can handle risks like this if he chose and still be way ahead of A.

As it turned out though with investor B not being chained to his stock positions like A is, B decided that the sheer panic that hit the markets during that time did not portend the bullishness that he invested in these stocks to capture, and stepped aside and avoided most of this carnage. Once the sun came out again and it was safe to travel, he then took his ship out of the protection of the harbor and back out to sea, and actually made a nice profit out of the deal as investor A hung on and waited to get back to even.

While investor B’s stock ship was tucked away, he decided to switch to bonds for a time, because bonds were doing well and making money while stocks were bleeding so much. The risk with bonds was also very low at the time, unlike now where the risk has climbed up remarkably since then. This is the right way to use these things, when they actually are better and not during bull markets with stocks where bonds are very inferior in comparison, and even ignoring bear markets with bonds which involve not only getting reduced returns, they place us in positions where a loss instead of any gain is probable.

This also lights the way for the final key principle, managing returns. Investor B points out that neither he or A are planning on using this money anytime soon, with retirement many years away, and wonders why investor A has such a fear of intermittent drawdowns in the first place. We do need to make sure that we keep risk manageable, but if we are indeed in for the long run, while we should look to manage the dips that come along the way, we need to keep these things in perspective and not use these as reasons to want to choke our returns by grossly mismanaging risk.

With these four basic principles properly understood, while this may not in itself make us very good at investing, we are at least not actively seeking to sabotage our results and at least know what we are supposed to be doing, which is far better than having no idea what we are doing and end up choosing the wrong things all the while, and even being none the wiser. Investors need to choose to wise up.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: [email protected]

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