Read an Excerpt
Rule the Freakin' Markets
How to Profit in Any Market, Bull or Bear
By Michael Parness St. Martin's Press
Copyright © 2002 Michael Parness
All rights reserved.
ISBN: 978-1-4299-7924-5
CHAPTER 1
The Knucklehead Within
Identifying Your Type
This chapter covers:
Why everyone is vulnerable to self-defeating behavior Common types of self-defeating and risky behavior Why you must recognize your own inner knucklehead How to control your inner knucklehead and become a successful trader
Your Inner Knucklehead Wants You to Lose Money
Sigmund Freud said that deep down inside, everyone has a secret death wish. It's the same with trading stocks. Everyone, deep down inside, has a financial death wish. The difference between winners and losers is how well they control it.
Would Freud have made a great stock trader? I don't know for sure, but I think he might have. Everything about the market makes way more sense if you look at it in terms of human nature and psychology. (Some days it's tempting to think there's some kind of abnormal psychology involved, some kind of mass delusion or psychosis, but it's actually much simpler than that.) Anyone on Wall Street will tell you that the market is driven by only two things — greed and fear — and, on a grand scale, the power of traders' self-interest really does control the market.
But not everything investors and traders do is in their own self-interest. This is especially true for newbies and nonprofessional traders. It's a weird quirk of human nature that we find unconscious ways to sabotage our own efforts, to do things that hurt rather than help us. This tendency is our financial death wish, which I call our "inner knucklehead." It's what makes us do stupid things and then wonder why we did them. You may find this whole idea hard to digest at first. You'll ask, Why would anyone except a very troubled person try to fail financially? Why would anyone engage in self-sabotage in a place like the market, where everyone's looking out for themselves? Hey, Batman, riddle me this — what's the evolutionary purpose of a financial death wish?
TRADER TALK A newbie is a new, inexperienced trader.
I'll leave it to the psychology books to explain the theories. What I can tell you is that the financial death wish is real, and no one in the market is immune. I see traders fall victim to it every day. The deep motivations are probably different for everyone, and figuring out yours is a job for your therapist. The important thing is for you to recognize your inner knucklehead and prevent it from losing your money.
Common Self-Defeating Trading Behaviors
Some examples will show you what I mean. Here are some very common self-defeating behaviors that most traders think they're immune to. But if I had a dollar for every time I've seen these going on, I'd stick a coupon in each of these books entitling you to a free sushi dinner, on me!
1. The newbie's exuberant leap into the market.
During a bull market, how many thousands of people open up online brokerage accounts? How many others start buying particular kinds of stocks because they've heard they're hot? Many hundreds of thousands. Lots of these people have absolutely no experience in stock trading or investing. Many are so excited about becoming a stockholder or market player, or just raking in the ka-chingos, that they can't wait to jump in, ready or not.
It's not only new traders who leap before they look. Even experienced traders can feel a rush of irrational exuberance when they see something that might be too good to miss. Besides, it may seem easier and more pleasant — at first — to jump in and let the chips fall where they may. And that's exactly what will happen, because jumping in half-assed is a casino mentality. It's no better than gambling at the racetrack, at cards, or at a roulette table. Few would disagree that compulsive gambling is self-defeating behavior, but our society's blind faith in the stock market makes us believe that throwing money at stocks is somehow different. It isn't different. It's your inner knucklehead at work.
The way to control this species of inner knucklehead is to learn and practice the discipline and skill of trading. Think of it as a form of martial art, with its own kind of spiritual beauty. The chapters that follow will help you learn. It's your job to continue to learn every day and to use what you know to make intelligent decisions on every trade. That's the way to make the ka-chingos!
2. The passive investor's blind faith in Wall Street's advice.
Blindly following the investment advice of a broker or analyst is one of the most financially self-destructive things I can imagine. I should know — I did it not once but twice and, baby, I lost big both times! It's tempting to just put your money "in good hands" — or what you want to believe are good hands. You imagine that it's like putting your valuables in a safe-deposit box. After all, the market always goes up in the long term, right? And isn't buying stocks the best way to invest? Haven't lots of people gotten rich by making good investments? Isn't it the American way?
What you have to realize is that the market is nothing at all like a safe-deposit box. Neither is a stockbroker. First, there's no safety in the market. Second, a broker's interests and your interests are not the same and actually are often completely opposed because the broker gets paid a commission when you buy stock, whether it's a good investment or not. A broker's primary job is to make stock transactions. Putting blind faith in a broker is like expecting McDonald's to design a healthy nutritional plan for you. They'll recommend whatever they've got for sale, whether it's good for you or not. This is why all brokers suck!
Equity analysts, like the ones on TV, are even worse. They're true salespeople who are paid to talk up the stocks of companies that are their firms' clients. All analysts suck! And mutual fund managers are required to invest their funds' money whether it's a good time to do it or not — and collect management fees whether the funds gain or lose money. In Chapter 6 I'll tell you about the "window dressing" manipulation that fund managers engage in to make their funds look like winners every quarter.
Your inner knucklehead loves to watch you sit back and put your trust in the judgment of others. It's so much easier than educating yourself, and they're professionals! But it's never their money at risk, and they profit from your transactions whether you do or not.
This misplaced trust can be overcome once you decide to take charge of your own financial future and learn how to beat the Wall Street suits at their own game. There's a lot of joy in coming out miles ahead of these socalled professionals!
3. The small account holder's failure to diversify.
Another temptation your inner knucklehead will dangle before you is to put all your money into one or two stocks that you hope (always beware of that word!) are going to do ridiculously well. The reasoning would be: Why dilute the ka-chingos by spreading the money among too many stocks? Some investors with very little capital (under $5,000) might also be tempted to put all their eggs in one basket because trading fees significantly cut into profits on very small investments. (See Chapter 2 to find out how to assess your trading capacity realistically.)
The problem with failing to diversify is that, even though diversification may dilute the profits you make on a single stock or sector, it also softens your losses if that stock or sector crashes and burns. Putting all your money in one place is very, very risky — just the kind of thing your inner knucklehead loves to do, since all it can see are the huge ka-chingos if things happen to work out well. Your inner knucklehead lusts after the upside and ignores the downside.
Once again, the way to keep your inner knucklehead under control is with education and discipline. You'll learn a lot about both in the chapters that follow.
4. The perfectionistic day trader's refusal to accept small losses.
Some people think they're pretty good at trading, and they let this belief get in their way and make them worse traders in the process. People who want to be good at trading — and who doesn't? — sometimes think they have to be right on every trade. When a stock they thought would go up starts heading down instead, and it's clear that the trade is not going according to plan, they want to hold on to it until it goes back up again, and they convince themselves it will do that eventually. They don't want to lose a cent on a single trade, and in most cases this really boils down to being unable to admit that the trade didn't work out.
This makes no sense and is nothing but stubbornness. And, if you think about it, isn't it incredibly arrogant to think you could be right about every trade?
There are several reasons why holding a losing stock that keeps going down and down, losing more and more money, is financially self-defeating behavior. First, there's a real chance that the stock will never recover to the break-even point. Second, even if it finally does recover, holding a loser ties up your capital and makes you unable to take advantage of good trading opportunities for days, weeks, or months. You'll finally make it back to zero instead of making kachingos, which is the reason you're trading in the first place. Third, obstinately holding on is an example of the unfocused, planless trading and lack of discipline that eventually cause traders to lose all their money.
But wait! says your inner knucklehead. It's stupid to take a loss right away, because the stock is bound to make a comeback as soon as you sell it — some variation of Murphy's Law will make it come back!
Sure, this is possible. Anything is possible, but what matters is what's likely. It's at least as likely that the stock will go even lower before it turns around. At that point, if you had gotten out earlier and there was a good, sound reason to believe that the stock would start back up, then you'd be free to go for it — making some ka-chingos by rebuying it at the lower price.
And even when a stock does go up again right after you've sold it, you have to realize that there will be many, many more times when this won't be the case if you make a habit of clinging to bad trades. Holding on to losers is a losing strategy.
Every trader must be willing to take small losses. If you're not willing to take small losses or don't have the discipline, you shouldn't trade.
5. The emotional trader's mood swings between invincibility and panic.
Remember the story of Mr. Loser? When the price of his stock rises, he feels invincible (I am one with the market!) and buys more and more. When the price goes down, he panics and sells and wallows in self-hatred (I suck!). Instead of buying low and selling high, Mr. Loser buys high and sells low, which is a fail-safe way to lose money.
The emotional trader needs to understand how the market works, what to expect from it, and how to get what he or she wants from it. Then he needs to develop the skill and discipline to quiet his emotional inner knucklehead and listen to his own good judgment.
6. The distracted trader's attempts to trade on bad days.
There will be days when you just shouldn't trade. There will be days when you're simply not up to it. If you're feeling sick or upset — if you have the flu, have just experienced emotional pain or a nasty surprise, or are feeling angry at the world — just take the day off. If you're physically hurting, you won't trade well because you won't have the energy to concentrate and make yourself do the right thing. You won't care enough, and you'll just screw things up. And if you're emotionally hurting, you really won't care enough. You may be grieving, feeling guilty, or hating yourself. Unconsciously, people in those emotional states don't want to win. Unconsciously, they want to do things that will hurt or punish themselves.
No one has to trade every day. On a bad day, be kind to yourself. Take a walk or a nice hot bath. Leave the market for another day.
Which patterns apply to you?
These are only a few of the common mistakes that traders make and keep repeating. I'm sure some of them will sound familiar. Which ones can you relate to? What other kinds of risky, money-losing behavior have you found yourself repeating? These mistakes, and others like them, are often caused by the "seven deadly sins plus fear" I discuss in Chapter 5. Like a little red devil on your shoulder, your inner knucklehead will try to convince you to commit those trading sins. Your inner knucklehead operates by talking you into taking unnecessary and unjustifiable risks. It convinces you that taking these risks makes sense.
This is the time to identify the forms your own inner knucklehead likes to take. It often morphs from one form to another to try to catch you off guard. Your job is to learn to recognize your inner knuckle-head at work. Once you can recognize its influence, you can respect its power and control it.
I should know. It took me a while to figure out the ways I was unconsciously sabotaging my trading and to avoid making the same mistakes over and over. When I first started out I traded emotionally, always afraid to miss the boat, chasing stocks up and paying too much for them, then selling them in a panic for large losses. I repeated this cycle enough times to wipe out my entire investment. Finally, by learning to trade with a plan, with planned entry and exit points for all my trades, I began to control this losing pattern.
Once I learned how to buy and sell more intelligently, I found that my biggest weakness was failing to diversify — getting carried away with one promising stock until I'd put so much money into it that it became risky. In Chapter 5, I refer to this as the sin of Gluttony. You could also call it "going nutso on one trade." This type of bad trading cost me a fortune several times. The first time, I overloaded my account on a single stock for an IPO spinoff play that I thought would be the mother of all trend plays. What I didn't realize at the time was that the market was starting to turn sour and the trend was weakening for the time being (see Chapter 6 for more on how and why trend plays work). Though the percentage loss wasn't crushing, I had so much money tied up in that one stock that I lost all the profits I'd made in the preceding three months.
The second time I let Gluttony rule my trading, I was only slightly smarter. Instead of putting most of my money into one stock, I put it into a lot of stocks — in one sector. That sector, the biotechs, had been ultrahot, with many large and small issues running up from 15 percent to 40 percent a day, and sometimes even several hundred percent in a day when good news broke. So I had a whole stableful of those fine little racehorses — they made up over half my portfolio.
Well, after a little while the biotechs crashed in a spectacular heap of test tubes and lab coats. I had even seen that trouble was on its way, but my positions were so big that I actually couldn't sell them out fast enough to avoid huge losses. (You never thought having a huge account could be a problem, did you? See Chapter 2 for a discussion of the special problems of very large accounts.) There I was, trapped like an enormous, slow beast whose power can't save it from its fate.
Since then, I've learned to keep a close eye on my inner knuckle-head's gluttonous tendencies. I've learned to just say no to the temptations of going whole hog on any stock, sector, or single type of play. I've learned to stay nimble and move with the market, rather than expect the market to do whatever it is I have in mind.
My other major weakness is still an emotional one: specifically, emotional bad days. But now I know that I don't need to trade every day, so when I'm upset or just not in the mood to trade, whether it's because I'm burned out on it or because I have too many other things on my mind, I just do something else. It takes attentiveness to recognize when you're not up to trading and discipline to back off on those days, but believe me, it will pay off royally. On the days you trade, baby, you've got to play to win!
(Continues...)
Excerpted from Rule the Freakin' Markets by Michael Parness. Copyright © 2002 Michael Parness. Excerpted by permission of St. Martin's Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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