Why do you invest in the stock market? Part1

This is a guest post.

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Christopher Colvin 

Chris is the Founder, CEO and Managing Director of JLCC Capital Management, LLC, a private investment company that provides investment opportunities through equity-based and private equity funds. JLCC Capital manages The Crucible Fund, a long-short US equities fund that focuses on ETFs. Chris founded JLCC Capital Management and The Crucible Fund with his partner, John Lee, in 2005, and they began trading operations in January 2006. Chris and John met when they worked together as stock brokers in New York City. They began to see fundamental and disturbing flaws in the transactional retail brokerage business that prevented clients from making money consistently. So, they developed a trading strategy and struck out on their own. Originally having designed their strategy for trading in individual common stocks, Chris began back-testing the strategy on ETFs in 2007. Chris and John switched over completely to trading ETFs in August 2007, when market volatility started to crank up. Their strategy was put to the ultimate test in 2008, and, despite the extreme volatility in the financial markets, they produced a net return of 36.4% for the year. Since their switch to ETFs, Chris and John have produced a total return net of all fees of 87.3% as of April 30, 2009.

Chris is happily married to Jessica Yunker, a licensed acupuncturist and traditional Chinese medicine practitioner, and they live in New York City.

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Why do you invest in the stock market?

If your answer is anything other than, ‘to make money,’ then stop reading, because I cannot help you. A great percentage of people, tragically, invest to satisfy needs that have nothing to do with making money, and frequently have everything to do with losing money. This, incidentally, is why businesses like TD Ameritrade and MF Global will be around in one form or another for a very long time. …Bars too. So, what does it mean to invest? Unless a gain on an investment can be realized and pocketed, there is no point to investing. If Warren Buffett’s cost basis on 1million shares of GE is 25¢, and he gifts his GE shares to a charity when the stock is $50, he looks like a superstar because he ‘made’ all this money by correctly buying and holding the position. Buffett is the best at what he does and is truly alone in his class when it comes to long-term investing. However, if the charity simply holds the position with no clear plans to liquidate it, or, perilously, borrows against the stock on margin, and the position drifts down into the single digits, and then, at the worst possible time, the charity needs to sell the stock in order to fulfill their operational needs, the gifted stock position valued at $50million is suddenly just a fraction of the original gift size, and hardly what it seemed at first. Therefore, if you have no exit plan for your investments, you have no plan, period, and your ability to make money in the stock market becomes nothing more than pure chance.

Stocks are paper, and, therefore, each stock investment must be viewed as a trade – a position that you enter by putting money at risk, and at some point exit, retrieving more than you started out with. Simple enough. Really – it is. There is no need for complexity in trading. What most investors lack is a simple systematic approach to trading profitably. It is utterly hopeless to attempt to attain, understand, evaluate, and then act correctly on every piece of information that affects the equity markets. So what are we to do? What are we to rely on to consistently make money in the market? Since our goal is to take out more money than we put in, the only thing that matters is price. You go long because you aim to sell at a higher price, and you go short because you aim to cover at a lower price. So, one must be a student of the movement of the price of equities, i.e. price trends, in order to trade successfully.

Am I preaching to the converted? Let’s not pretend that we don’t stray from our core trading strategies from time to time trying in order to justify the position we’ve just entered. It starts out innocently enough: your system triggers a buy, and you go long the fertilizers…you’re up 3% – nice entry - off to a good start…quickly you’re up 5% – your system is working great - rock n roll…your position drifts down 2% – you scoff at those foolish bears, who’ve been wrong the whole way up anyway…back to break-even – it’s a natural pull-back - steady as she goes…-4% – you call a few friends who you know will reassure you that your position is solid…back up near break-even – look at those fools on CNBC wondering if this is ‘the beginning of the end’…+2% – slight bearish RSI divergence, but it’s no big deal – you’re back on track…-5% – let’s wait for the oil inventory numbers…-8%...um…-10% – but India and China are supposed to be consuming everything except anti-matter in ever-increasing quantities for as far as the eye can see!...-15% – but that perma-bear just turned bullish!!! -- what the hell?!... and before you know it your position is well below your ‘mental’ stop-loss, and your news-searching and rationalizing have steered you deep into the Crab Nebula, light-years away from your core trading strategy. We’ve all played that game too many times, and we all know how it ends.

Even if you have a workable trading strategy you will get taken off course. You absolutely know when you are straying from your core strategy – when you feel yourself about to stray, stop and ask yourself, “Should I be trying to scalp 2% out of this short-term move even though I trade weekly trends?”, or, “Should I really be holding onto my position for three days even though part of my strategy is to go home flat every day?” The solution to straying is to devise a system and test it rigorously for robustness in all types of market environments – this will give you complete confidence in your strategy. (I will leave the fundamentals of strategy generation for a future discussion, as it is an important topic unto itself.) Devising a profitable trading strategy is much easier than sticking to it, but it helps immensely if you have a system that you believe in.

Once you have a system in which you are confident, study what is important for the current trend in the timeframe in which you trade – each trend is always different from prior trends in some way, and you must correctly discern those differences, not the similarities, which are usually quite salient, in order for you to apply your core strategy correctly. That is, study what price levels/trend-lines/moving averages/oscillators, etc. that the market is reacting to in the current trend. Maybe in the last uptrend the market bounced every time it pulled back to the 30-day simple moving average (SMA), but this time it is bouncing at every test of the 15-day SMA. Maybe in the last uptrend the market pulled back every time the RSI hit 60, but this time it’s not pulling back until the RSI hits 70. News flow and fundamentals will always be different in different trends, and there is no reliable objective way to measure the impact of news and fundamentals on the market. We can say the average P/E of the S&P500 over the past 50 years has been 16, and currently the P/E is X – but how does this help you to make money? If the P/E is currently 22, then should we just short the market, assuming it will revert to the mean? What if it reverts to the mean not via a drop in price, but rather via growth in earnings? Then shorting would be a major misstep. Or what about the 4^th quarter of 2008 when the P/E was Ø because there were no earnings for the S&P500 for that period? How does a P/E of Ø revert back to the mean?? Taken seriously, trading based only on analysis of fundamentals and underlying businesses assumes that others will eventually come to the same conclusions that you have come to. If others do arrive at the same conclusions, this will manifest itself in price movement – market participants vote their opinions by buying and selling, which determines the price of equities. So why not just cut out the guesswork and go straight to the price action so that you have an objective idea of when others have come to those conclusions and how strong their opinions are?