Your best investment strategy? Think like a General

Behavioural finance author Ken Norquay says generals need to be cunning, decisive, resourceful, while privates are loyal, obedient, self-sacrificing. As an investor, you need to establish the best long term investment strategy to achieve your goals and objectives.

Learning is most difficult when the lesson goes against our deep-rooted instincts. In previous articles, I have emphasized how important it is for investors to neutralize their own instinctive financial fear and greed. The theory of contrary opinion tells us greed is most prevalent among investors at long-term market tops, fear at market bottoms. To improve our performance as investors, we need to become sellers at tops and buyers at bottoms. That investment strategy is easy to understand, but hard to do.

In my investment book, Beyond the Bull, I use the analogy of a financial war to help investors achieve emotional objectivity. In war, there are privates and generals.  Privates are obedient, loyal and self-sacrificing. Generals are cunning, decisive and resourceful. I encourage investors to think like generals, not like privates.

Can we learn to be cunning and decisive? How are these qualities learned? When I was a young officer trainee in the Canadian Forces, they taught us these mysterious lessons through a variety of military exercises. Let’s try an armchair exercise to re-learn lessons from the past.

The Exercise: managing through boom and bust

Imagine you are a strategic investment professional, a general in the financial wars. You accept moral responsibility for your clients’ and your own financial well being. Imagine how that would have felt as the dot-com market topped in 2000. The stock market had risen sharply from 1991 to 2000; and the market crash of 1987 lingered as a sober reminder of how wrong things can go so very quickly. Take some time to imagine what it would have been like to have served your clients so well with that mind-set of cautious optimism.

Then, quickly scroll time forward two years: the market has dropped in half and the dot-com stocks by 90 per cent. Don’t dwell too long on this, but don’t forget it!

Learning from mistakes … our own and others’

Now, imagine the long-term top in the Canadian stock market in 2008. You are still the investment professional, the general. Dwell on these feelings and memories. It is important to learn more from the mistakes of others than from our own mistakes. The best way to learn from others is to imagine yourself as others.

Put yourself in the shoes of a professional strategic investment manager

How much this exercise helps you depends on how effective you are at using your imagination. Sincerely try to imagine what it would have felt like to be your own advisor at those times. As a professional, you would have been responsible for hundreds of other people’s portfolios in addition to your own. The emotions of professionals at stock market tops, and especially at bottoms, are many times greater than the emotions you may have toward your own personal losses and gains. It’s hard to be humble and cautious at tops because you’ve done a good job. Conversely, at bottoms, it’s hard to even show up for work. Please do this exercise sincerely: really imagine what it might have been like . . .

If you were a strategic investment professional, a financial general, instead of only a private investor:

1. What are your actual responsibilities to your clients? Think about the moral and financial aspects to this.

2.  What emotions would you feel toward your clients? Emotions that I have personally felt towards my various clients over the years include protectiveness, pride, annoyance, guilt, shame, dominance, parental, affection, aloofness and empathy.

3. Would you have learned from your clients’ financial pain? And from your own mistaken advice? For me, the latter had the biggest impact, in terms of learning.

4. How easy is it for you to admit when you’re wrong?

Use more than imagination: Dig up the documents

Really get into this exercise; try to find copies of your old monthly or quarterly account statements. Try to review the decisions you made about buying or selling those securities at that time. Try to find media articles written a few months before those tops. Our goal is to remember the feelings from the point of view of a strategic investment professional (i.e., a general) and not so much from your own point of view as a private investor.

Learn from history

In your imagination/memory, how cunning were you? How resourceful? How decisive? What should you have done? What do you wish you had done? And don’t be afraid . . . after all, it’s only your imagination. Our goal is to learn cunning, decisiveness and resourcefulness by vividly remembering and imagining certain events in economic history. It’s impossible to change history; but we need to learn from it.

Applying these lessons to today’s market

Let’s keep our general’s hat on while we review the ebb and flow of the current market top and try to determine our investment strategy.

This bull is long in the tooth

The uptrend in today’s U.S. stock market began in March, 2009. That means this is a “late-stage” or “mature” bull market, not the beginning of something.  The market top in 2000 was preceded by a nine-year uptrend and the 2007 top was preceded by a four-year and eight-month uptrend. Both were followed by approximately 50 per cent declines.

How market tops and bottoms behave

Stock market tops, in general, are long and drawn out. Bottoms are sharp and volatile. One sign that the current market uptrend is ending is the fact that the S&P500 composite index first hit 2000 in August, 2014, traded both above and below that level for six months, and is currently only five per cent above that level. Yes, it’s an uptrend, but it’s weak. If it turns out to be a top, we should expect the down moves to become increasingly more dramatic, and the up moves increasingly weaker.

Market technicians refer to this market action as “distribution”. During distribution, the “smart money” stealthily sells stock to the not-so-smart money. The result is a drawn out, sideways, trendless market. When demand finally dries up, the sellers increase their activity, and the downtrend emerges.

Think like a trader

How does a cunning strategic investor behave in this situation? Our advice? For now, think like a trader: become even more risk sensitive than usual and think short-term. And, above all, don’t give back the profit you have made since the March 2009 bottom.

Good news versus sluggish markets

In a previous article we re-defined the terms “bull market” and “bear market.” A bear market is a time when investor mood changes from optimism to pessimism. In a bull market, mood goes from skepticism to optimism. At tops, we expect the financial press to be full of favourable financial news and investors to believe it. The news that Iran has agreed to the international regulation of their nuclear program is wonderful. And news of President Obama’s new approach toward Cuba is another breakthrough. Record high earnings in the S&P500 stocks is great news too! Isn’t it interesting that the stock market is still not surging to new highs?

Central banks and fundamentals

“All right, General,” we ask ourselves, “what is the effect of the massive liquidity that the world’s central banks have been injecting into the monetary systems?” Usually, with easy money, stock markets rise, business activity increases and, in the past, inflation moves up. Has that happened in the U.S.A.?

Certainly the stock market has gone up. And business activity, as measured by the earnings of S&P500 stocks, is up as well. And U.S. house prices have risen from their junk-mortgage lows. Canadian house prices are climbing too.

But where is inflation? Canada loves inflation! Canada benefits significantly from rising prices in resources. However, energy prices have dropped in half and precious metals are low. Copper prices have dropped by 40 per cent and nickel by over 55 per cent since 2011. “Something is wrong, General.” Has this ever occurred before? Has there ever been a time in modern history where aggressive central bank monetary stimulation has not resulted in inflation?

Unfortunately, there has: in the 1930s. The “something wrong” turned out to be deflation.

“Well, general, what are we going to do about that?”

Our advice

1) Review your financial / strategic investment plan as a general, not as a private. Be sure it has an escape plan so you won’t have to repeat the folly of this century’s first two bear markets.

2) If you love the market’s action and want to speculate for short-term gains while the market is still rising, stick to the gold mining stocks for now. The price of gold appears to have bottomed in November, 2014 and has held up in spite of the pressure from a soaring U.S. dollar. Many junior gold mining stocks bottomed a year earlier, in 2013.

3) Speculators may also consider trading junior energy stocks. Although there is no firm evidence that the downtrend in energy and energy stocks is over, energy prices are stabilizing and the risk is much lower now than any time in the past year.

 

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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