Trading Realities: First Principles
This book is designed to help investors understand the economic and political forces that drive financial markets and to invest alongside those forces instead of against them. It also provides a blunt assessment of the limitations that most private investors face. Understanding these limitations and being able to manage risk are as important as choosing the right investments.
The following basic principles are central to the theme of this book:
- Financial markets, and stock markets in particular, always move in the direction that will do the most damage to the most investors. There are valid mathematical reasons underlying this assertion. In the most basic terms, when a large number of investors are on one side of the market and the market moves against them, the short-term losses create a wave of activity that becomes self-reinforcing. It is for this very reason that high-volume days with the most aggressive buying tend to occur just before sharp corrections.
- Financial markets are interrelated. Understanding the effects of one market on another is critical to successful investing. Nobody should ever invest in a market that doesn’t make sense to them. In this regard, it is critical to be able to rationalize moves of the market with changes in the economy and financial news.
- Individual stocks tend to be swept along by the market. Even the best companies suffer declines during a market correction, and the worst companies can rally in a strong bull market. The gap between market and individual stock performance is not always obvious.
- Many investors blame the market when their stocks decline and credit themselves with wise investing when the same stocks rise. They never take the opposite view—that is, they never believe that they’re lucky when they make money and that their losses are due to bad investment decisions. Taking a more pessimistic view will make you a better investor. It will drive you to work harder and be more diligent. Blame yourself, not the market, for losses.
- Experienced investors tend to overrate their knowledge about the companies they invest in. Gaining insights not already known to the market is a very difficult undertaking. Quarterly reports and analyst reviews cannot fill the gap. If you can’t describe a company in terms of its revenue streams, sales pipelines, distribution channels, product roadmaps, and business models, then you don’t understand the company well enough to become a shareholder. Recognize that buying shares of stock is equivalent to purchasing a minority stake in a company. Don’t invest in a company that you wouldn’t feel comfortable owning, and if you can’t gain that level of comfort then don’t invest.
- The ability to interpret and understand government reports and news releases is a critical skill. These reports contain a wealth of information buried at a level of detail that most investors try to avoid. It is a mistake to let the financial news media interpret this information for you. Complexity and detail are your friends because they allow you to gain an advantage over the market and lazy investors who are unwilling to do their own homework.
- Understanding and avoiding risk is a key component of basic investing. Understand the relative risks of different financial instruments and avoid overusing leverage. Don’t be fooled into believing that interest-earning investments are automatically safe. The most dangerous three words in the investment world are “can’t possibly happen.”
These concepts will weigh heavily in our discussions. However, they are not intended as simple guidelines and, on their own, they cannot be used to choose profitable trades. They are intended as background themes that can be used to guide your thinking.