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Jeff Saut: Losses Part of Trading

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Perfection on Wall Street is impossible.

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Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"Most people acknowledge that losses will happen regardless of the type of business venture. A light bulb manufacturer knows that two out of three hundred bulbs will break. A fruit dealer knows that two out of one hundred apples will rot. Losses per se don't bother them; unexpected losses and losing on balance does. Acknowledging that losses are part of business is one thing; taking and accepting those losses in the markets is something else entirely. In the markets, people tend to have difficulty actively (as opposed to passively as in the case of the fruit dealer and the bulb manufacturer) taking losses (i.e., accepting and controlling losses so that the business venture itself doesn't become a loser).

This is because all losses are treated as failure; in every other area of our lives, the word loss has negative connotations. People tend to regard the words loss, wrong, bad, and failure as the same, and win, right, good and success as the same. For instance, we lose points for wrong answers on tests in school. Likewise, when we lose money in the market we think we must have been wrong."
-
What I Learned Losing a Million Dollars (Jim Paul and Brendan Moynihan)

Everyone knows how to win; but, few know how to lose! Yet the secret to making money in the market is knowing how to lose, or how to control your losses. Listen to the pros:

"I'm always thinking about losing money as opposed to making money. Don't focus on making money; focus on protecting what you have."
- Paul Tudor Jones

"The majority of unskilled investors stubbornly hold onto their losses when the losses are small and reasonable. They could get out cheaply, but being emotionally involved and human, they keep waiting and hoping until their loss gets much bigger and costs them dearly."
-
William O'Neil

"One investor's two rules of investing: 1) Never lose money. 2) Never forget rule No. 1."
-Warren Buffett

All of those pros have different market philosophies. They have contradictory strategies for making money.

Some are traders; some are value players; some are growth-stock advocates; others are emerging-growth seekers; etc., etc. However, the message is clear: Learning how not to lose money is more important than learning how to make money. And in learning how not to lose money you have to evaluate risk. It may be helpful to go through the following exercise in risk reasoning:

One hundred dollars made in a money market account buys just as much as a C-note ($100 bucks) made on a flyer in the stock market. But the risks taken to make each $100 are vastly different. The risk in the money market account is virtually zero. The risk in the flyer can be 50% or more. Therefore, the risk-adjusted incentive always favors the money market account. Hence, the money earned at great risk should be worth less than the money that comes more safely. This principle is one many stock investors should apply to their risk-adjusted discipline. In other words, just as all the dollars earned should not be seen as equivalent, all risks are not created equally!

Risk-adjusted investing: The concept of it is woven throughout Benjamin Graham's book The Intelligent Investor. This is particularly true in the last chapter titled "[The] Margin of Safety as the Central Concept of Investment."

Listen to this quote from said book, "The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price." This "central concept," ladies and gentlemen, is precisely why "sometimes me sits and thinks and sometimes me just sits." To be sure, I'm always trying to develop a "margin of safety" to give us the "edge" whereby if I'm wrong in my analysis I can exit the position without serious incident of loss. Whether the "edge" is an outsized dividend to give me a "downside cushion," or buying a dollar's worth of assets for fifty cents, the price paid for the investment/trade is extremely important. As stated in the aforementioned book, "Graham is saying that there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a 'sell' when its stock price goes too high, while the worst company is worth buying if its stock price goes low enough."

Putting these thoughts in perspective regarding the current stock market environment, I entered the New Year in "cautious mode," yet was bullish at the January 2008 "lows." On a trading basis, I was cautious at the February "highs," but bullish at the March downside re-test of those January "lows." Again, I turned cautious in early May and subsequently left for Europe. Since then, I've averred that a downside thrust into the 1320 -1330 zone (basis the S&P 500 (SPX)) was coming, and have repeatedly said so. Obviously, the S&P 500 overshot my preferred target zone last Friday, yet participants should actually take heart!

Indeed, unless we're involved in a stock market "crash" (I put the odds of that as 1 in 10), it's currently Day 24 in the downside skein since the "selling stampede" began from the May 19th reaction high of 1440 (basis SPX). Recall that once they begin, "selling stampedes" tend to last 17 – 25 sessions, only interrupted by one- to three-session counter trend rallies, before they exhaust themselves on the downside.

Moreover, my firm's proprietary overbought/oversold indicator is more oversold than it has been in years. Further, last Friday's Dow Dump (-220 points) occurred on a quadruple "witch twitch" expiration session, accompanied by rumors that Israel was going to bomb Iran's nuclear facilities over the weekend.

Meanwhile, last week more market mavens turned bearish, punctuated by Royal Bank of Scotland's "call" for a full-fledged crash in the financial stocks that would cause the S&P 500 to lose 300 points by September.

I'll say it again, ladies and gentlemen: Unless we are into a stock market crash, these are the type of events seen around tradable market "lows." Now the typical pattern following a week like last week is for participants to brood about their losses over the weekend and show up Monday in "sell mode," leading to a Monday/Tuesday two-step to the downside that sets the stage for a bottom.

Since for the past few sessions I've recommended the scalebuying of the SPX whenever it traveled into our target zone of 1320 – 1330, I certainly hope the typical pattern plays this time. If not, I'll be stopped-out (read: sold), consistent with William O'Neil's comments, "The majority of unskilled investors stubbornly hold onto their losses when the losses are small and reasonable. They could get out cheaply, but being emotionally involved and human, they keep waiting and hoping until their loss gets much bigger and costs them dearly."

Verily, most investors don't want to be wrong and take a loss. They stubbornly seek perfection – a profit in every trade or investment. And, the neurotic pursuit of market perfection is the Achilles' heel of most investors. Perfection is impossible on Wall Street!

As Martin Sosnoff said in his book Silent Investor, Silent Loser:

"There is only perfection in the cemetery above Omaha Beach. There no crabgrass grows among the bright green blades cropped three inches above the earth. It is truly as Walt Whitman has said, 'The hair of the Lord.' And the crosses stretch out in that echelon of perfect longitude. The only perfection is in death."

The call for this week: Friday's Flop (-220 DJIA) produced a pretty rare event in that all of the D-J Industrial Average (DJIA) components were negative on the day. This too is the kind of capitulation action seen around market lows. Unsurprisingly in last week's carnage, the S&P Financial Index took out its March low yet, surprisingly, of all the indices I follow, only the economic sensitive D-J Transports were "up" on the week (+0.9%), which is pretty amazing with crude oil at $135/bbl.

The real winner for the week, however, was sugar, which gained 13.8%! As for me, I'm pleased with how well my recent investment recommendations (Linn Energy (LINE), Embarq (EQ), Alaska Communications (ALSK)), and of course most of my energy stocks weathered last week's storm. And this morning crude oil is higher again (+$1.55/bbl.) even though Israel didn't attack Iran over the weekend.

With the higher opening, look for attempts to sell stocks back down. If those attempts fail to gain much traction by tomorrow's closing bell, the odds of a rally improve markedly.


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No positions in stocks mentioned.
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