We first noticed it a few years ago, when we outlined the Chicago City Council’s attempt to ban smoking at all bars and restaurants. Of course, smoking in any large buildings and workplaces had already long since been outlawed.

Score one for the socialists. Thanks to opportunistic local politicians and an aggressive lobbying effort from liberal think tanks, the smoking ban passed, making it illegal to smoke cigarettes — a legal substance — in any bar or restaurant within city limits. Public-health advocates have heralded the move as a major score for the best interests of smokers and nonsmokers alike.

As usual, however, these immoral do-gooders miss the point completely. Despite the fact that they serve the public, bars and restaurants are private establishments, meaning that their smoking policies are only the proprietor’s to determine. Some restauranteurs might choose to permit smoking in certain areas or throughout the entire establishment. Others might choose to ban smoking completely. The point is that it is not the public’s (read: politicians’) right to interfere with legal activities taking place on private property. It is quite simply none of their business.

Nobody is forced to patronize a bar or restaurant that allows smoking, and nobody is forced to work at one either. If you are concerned about second-hand smoke or hate the way your clothes smell after a night out drinking at the bars, you should simply avoid those establishments that permit smoking. The onus is on you to modify your behavior, not the law-abiding businessman to accommodate you on his private property.

Pragmatists argued against the economic ramifications of the ban, although the real issue here has nothing to do with whether or not local businesses will be affected or if waitresses will lose tips. Plain and simple, the issue is property rights. Does the government have the right to micromanage your property, your business, your life for the benefit of the “public good?”

But it isn’t just smokers Chicago has sought to target. In recent months, the Windy City has become the nation’s second-biggest municipality to ban motorists from using hand-held cellphones while behind the wheel. Putting a cellphone up to your ear while driving in Chicago is now illegal. Those caught violating the ordinance face fines and a court appearance.

Fact: It’s illegal to run a red light, drive recklessly, or crash into someone else’s car. But using a cellphone while driving doesn’t infringe on anybody else’s rights, be it other motorists or pedestrians. If I’m able to safely operate a car while talking on the phone, what business is it of the city to prohibit this otherwise legal activity?

The truth is that holding a conversation on a cellphone while driving is no more distracting than talking to a passenger, tuning the radio or adjusting the rear-view mirror. Consider that the alderman didn’t see fit to ban drinking hot coffee, disciplining your kids, putting on makeup or styling your hair while driving, all of which are significantly more distracting than simply talking on the phone. In a free society, a driver should be able to determine if he is able to safely speak on the phone while driving. What’s illegal is causing an accident, not innocently carrying on a conversation on the phone. The law is just another “get tough” stunt designed solely to exert more control over the lives of otherwise law-abiding citizens.

Moreover, now motorists have to drive while grappling for an ear bud, which many find even more distracting than simply using the standard handset with which we’re all familiar. Some motorists report the headset cord gets caught in the gear shift, which could lead to a dangerous inability to control the car in an emergency.

Forget the total lunacy of talking on the phone in a neighboring suburb, then being forced to either terminate the call or fumble with a headset as you cross into city limits. Forget the fact that the ban imposes a multimillion dollar tax on excellent drivers who are now forced to buy headsets they didn’t want and would rather not use. Once again, the real issue here is how activist local governments are increasingly determining the lifestyle choices of citizens, sacrificing the rights of the individual in the name of a “public good.”

Once you permit government to begin regulating your life, it’s just a matter of time before they’ll start mandating just what you can eat. And continuing down this collectivist path, last week Chicago became the first major city in the country to ban foie gras, the fatty liver of geese that is considered world-wide to be a gourmet delicacy.

Environmental activists and animal lovers oppose the dish, which is made by force-feeding birds until their livers fatten to abnormal proportions. “Our city is better for taking a stance against the cruelty of foie gras,” Alderman Joe Moore, who sponsored the ordinance, told a local paper.

Our city is better? Well, I suppose it is as long as you didn’t like the occasional piece of foie gras! Like the smoking ban, the foie gras ban is another example of how the majority is able to trample on the rights of the minority. Few people eat foie gras or smoke — which makes restricting those activities an easy lay-up for politicians looking to score points as “doing something” for the community. If you don’t like foie gras, don’t order it! But banning it allows our Constitutional Republic to be turned into simple majority rule.

Forget that the vast majority of Chicagoans have never even tasted foie gras or that the city’s gourmet restaurants will have a disadvantage over neighboring cities that are able to offer the fare. What’s most amazing about the ban is that the alderman who supported it, in effect, grants greater rights to wild, plentiful, nonendangered birds than to his living, breathing human constituents. The human being’s right to eat — or not eat — foie gras has been superseded by the “rights” of the animal who doesn’t vote, pay taxes, or contribute anything to society besides the occasional bird dropping.

Although Al Capone is long dead, it’s apparent that Chicago is once again becoming a city of mob rule. Once a city famous for its scrappy support for capitalism and individual rights, the slow creep of socialism is transforming it into a highly regulated paternalist state where what you eat, where you shop, and how you drive are all up for grabs. In Chicago, providing you can get enough votes in the city council, anything goes.

And maybe you don’t eat foie gras, smoke or enjoy talking on a cellphone. But the point is that individual freedoms are being slowly obliterated. And although Chicago’s City Council is oblivious to the fact, one need not be a Constitutional scholar to understand it’s a trend that has significant long-term implications for our economy, our liberty and the very essence of the American way of life.

– Originally on May 01, 2006 by Jonathan Hoenig

The problem is that falling in love is easy. It doesn’t take much energy or critical thinking to quickly find oneself completely head-over-heels for a beautiful girl. The attraction is usually immediate and irresistible: Without warning, she becomes the sun who brightens up your entire world. In your mind, you quickly make plans to share a future and can’t imagine another day without her by your side. That’s love. And that’s where the trouble begins.

Love is equally as hazardous when it comes to your investments, where we often find ourselves falling for a particular stock and, thus, utterly devoid of the rational objectiveness that’s required to successfully manage a position or portfolio. Love in relationships can break your heart, but love in your finances will devastate your bottom line.

How do we fall in love with a stock? Sometimes we’re attracted by the profits an issue has provided over the years. For example, after rising many hundreds of percent during the 1990s tech boom, many investors couldn’t fathom the thought of selling Dell, Cisco Systems or Intel simply because the stocks have become almost members of their family, reliably churning out double-digit gains year after year. A winning stock, especially one held for a number of years, can be quite difficult to divorce oneself from even when the market’s price action suggests it’s time to bid farewell.

Oftentimes, we’re attached to the personal history behind a particular investment. So if your late father or dead great aunt left you 500 shares of General Electric (GE), you might be hesitant to exit the position out of respect for the deceased. The stock becomes a proxy for the real-life feelings for the individuals involved. Of course, it was the money they wanted you to have, not necessarily the shares in any one particular stock. Yet we personify them into a scrap of paper which might not have the same investment merit as when it was purchased 10 years back. My own grandmother gave me shares of Ford Motor (F) back in 1987. Considering the shares have fallen back near those late 1980s levels, I’m thankful to have long since exited the trade.

Most commonly, however, we’re in love with the idea of a particular stock — the fundamental rationale behind an investment which is often completely divorced from the actual price action occurring in the market. For example, for much of the last five years, patient investors have held onto shares of big pharmaceuticals like Merck (MRK) and Pfizer (PFE) because they were convinced the demographic “graying” of America would result in greater demand for prescription health care. And while demand for health care has grown, shares of two of the biggest players in the sector have fallen sharply for a myriad of legal and development-related issues. When we fall in love with an investment idea, we become preoccupied with believing a trade should work even when it isn’t. We hold onto hope even in the face of a rapidly weakening stock price.

And while it’s easy to fall in love, extracting yourself from its powerful grip can be an immensely difficult process. Although stocks are simply pieces of paper, we feel an emotional attachment to them that transcends a simple financial transaction. In most cases, we’ve not only invested our money into XYZ, but we’ve devoted our time as well. When you’re in love with a stock, you’ve likely pored over the annual reports, listened intently to quarterly conference calls and dug through the company’s financial statements.

Moreover, assuming it’s a well-known issue, we are reminded of the company at every turn, seeing it mentioned in magazines, on financial TV programs and all over Internet message boards. You can easily avoid taking calls from your ex-lover, but ubiquitous names like Nokia (NOK) or Boeing (BA) are usually harder to avoid.

Because love should be a selfish act, the best relationships are those in which the parties put themselves first. Unrequited love isn’t love at all, and if a relationship, be it with a person or a stock, isn’t serving your needs, try to rationally push yourself to cut the cord. Dow Chemical (DOW), for example, used to be a strong, well-known stock. Now it’s weak, with little indication a reversal is imminent. From my perspective, it’s an ideal time to kick it to the curb and move on to another dance partner.

A loveless life is tough to achieve. But you should most certainly drive for a loveless investment routine. The market isn’t a girlfriend or wife, and when it comes to the bottom line, it’s your head that should give the orders, not your heart.

– Originally on Apr 10, 2006 by Jonathan Hoenig

There is no sure thing. But after trading everything from stocks on the screen to futures on the floor, I’ve come to believe that the most simple and effective way to put the odds on your side when allocating assets is to follow what I believe is the golden rule: Don’t fight the tape.

Deciding whether a stock is “overvalued” or “undervalued” is totally subjective. Price, on the other hand, never lies. The tape is the tape and determining weather a security is strong or weak is easily visible to even the uneducated naked eye. When a market is strong, you might not want to invest in it, but I think you’re a major fool to stand in its path.

If you’re interested in fighting the market — friend, you’re going to lose. The market has an unlimited supply of capital and patience. We don’t. We harbor these fantasies that, now that we’ve bought our 500 shares, XYZ is likely to bottom out and rebound to all-time highs. Certainly my few thousand shares aren’t going to affect the price of IHOP Corporation (IHP), and even big players like Kirk Kerkorian — who lost a quick $300 million on a position in super-weak General Motors (GM) — can’t influence a market before it reverts to the laws of supply and demand. Unless you’re prepared to take a company private and have unlimited resources, the market can outbox you with one hand tied behind its back.

Of course, “the tape” refers to price action, which should be of dear concern even to those who evaluate a company’s fundamentals. While you can follow a company’s earnings or underlying economics, at the end of the day, it’s the stock we actually trade. And, yes, satellite radio has potential and I love Howard Stern, but that hasn’t stopped Sirius Satellite Radio (SIRI) and XM Satellite Radio (XMSR) from dropping up to 20% over the last six months. And, while the sector could easily stage a formidable rebound, for my money, I’d wait to see some sign of strength before fighting a persistent trend toward lower prices. If XM is worth $37, why not at least wait until it can trade at $22.50 first? Why do people insist on betting on the old, sickly horse instead of the young, strong stallion?

And that’s where my money goes. Opinions are unlimited but trading capital isn’t. The disciplined player only puts money into those few high-probability trades in which the odds are on his side. Fighting the tape is always an inherently low-probability trade.

Take, for example, the Dow Jones Transportation Average, which we profiled back in 2003. In recent months, the Transports have become major market leaders, driven by massive gains in stocks such as FedEx (FDX), Norfolk Southern (NSC) and even airlines like AMR (AMR).

Maybe you own the sector and maybe you don’t. You might think the gains will continue or that the real money has already been made. Regardless of your outlook for future prices, any rational person has to respect the fact that — for now — the Transports are strong. So don’t fight the tape. As long as the price action climbs higher, shorting them, which one could easily do with a security such as iShares Dow Jones Transportation Average (IYT), is lunacy. It’s a perfect example of a low-probability trade.

And perhaps this is the high for Transports. But if you’re bearish on them, I’d say wait until at least you see some signs of weakness before putting dollars on the line by shorting the stocks. For example, as we pointed out recently, you didn’t need to short Nasdaq at 5000 in order to make money on its decline. You could have easily waited until the first big break before initiating short positions and still come out with a grand profit in due course.

Bizarrely, it’s human nature to fight the tape even on a much shorter time horizon. Armed with a freshly funded E*Trade (ET) account, we naturally become hell-bent on standing in front of a moving freight train just to see if it bothers to stop. (Hint: It doesn’t.)

So with XYZ down four points within the first 10 minutes of trading, why am I instinctively drawn into the fantasy of buying a few hundred shares at the market and hoping to sell a point or two higher by the time “Morning Call” turns into “Power Lunch”? My experience is that, if you want to make trades, that’s by far your best approach. If you want to make money, that eagerness to stand in the market’s path is downright insane.

For one thing, as we always point out, playing for the short-term swings — a point here, a quarter point there — is by definition a loser’s game. What inevitably happens is that, because you’ve clipped your winning trades at such insignificant amounts, even a few big losers wipe out all the wins. The only winner in these “scalper” type of accounts is the broker, who, of course, earns his commission on every trade.

Moreover, what’s inherently problematic about this approach is that, by stepping into a stock that’s suffered a recent and large decline, you’re fighting the tape, trying to catch a falling knife that literally hasn’t stopped. And when you look at the sustained fall taken recently by stocks such as Mills (MLS) and PXRE Group (PXT), one is reminded of the danger of the “it’ll-bounce-back” mentality. Those who bought the weakness hoping for a quick two-point pop were likely stuck with losers that dropped 50% or more in a matter of weeks. Again, no strategy is perfect, but on average, you generally have less of them when you focus on following the tape, not fighting it.

– Originally on Mar 27, 2006 by Jonathan Hoenig

A market spends the vast majority of time rising, falling or trending nowhere. So I start with the notion that, out of the hundreds of days in which I’ll hold a trade, there’s only going to be one or two of them that actually constitute a top or bottom. From a purely statistical perspective, an investment strategy that banks on being able to pick those few days has the odds stacked against it from the start.

In truth, you don’t need to sell the top or buy the bottom in order to make money on a trade. The real scratch isn’t made on the top or bottom 20% of a move, but within the vast middle 60%. To that end, the disciplined investor should always opt to play for the big moves — essentially, an overall valuation shift — much more than a simple three-point pop in Google (GOOG) or Amazon.com (AMZN).

The patient approach simply puts the odds on your side: When a big move takes place, such as we saw in technology during the late 1990s, bonds in the early 2000s or commodities in recent years, there’s almost always enough gravy so that, one need not buy the bottom in order to make money on the trade.

Moreover, not worrying about catching the bottom allows one to become much more selective. Instead of chasing after every dead-cat bounce, traders should forgo the first few percent and wait for a market to show legitimate signs of strength before putting money to work. In my experience, this philosophy tends to keep one out of the impulsive, whim-driven trades with less-than-ideal probabilities of success. For example, although they have recently come back to life, hundreds of millions were lost calling bottoms in Merck (MRK) and Pfizer (PFE) over their protracted bear rout. The disciplined player lets a security get bullish before he does, waiting for positive price action ahead of committing capital. Truth be told, if you’re right in your analysis, the first 10% or 20% won’t matter anyway.

Conversely, if I believe a market is overextended or ripe to decline, no matter how bearish I might feel, I’ll wait for some price action to indicate that a decline is under way before moving forward and taking a short position. The best example is Nasdaq, which — despite many pundits’ revisionist history, didn’t exactly plummet from 5000 to 1200 in a day’s time. You didn’t have to sell the peak on March 10, 2000, in order to preserve capital or even make money on the short side — only to wait until the persistently weak price action confirmed your bearish outlook.

And although trying to buy bottoms (or sell tops) is foolish, millions of pompous SOBs do it, not because they want to actually make money on XYZ, but because they’re looking to bolster their own self-image. It’s an exercise that’s more focused on feeding their ego than their pocketbook — those who do it are looking primarily for a story to boast about at a dinner party or with drinking buddies. If it’s accolades and attention you crave, you’re better off just buying a Porsche or fancy watch. Over time, trying to pick tops and bottoms will be a much more expensive proposition — with nothing to show for your effort.

Because we only know through the benefit of hindsight if a top or bottom has been made, it’s also helpful to make sure the behavioral indicators support a position before you go ahead and pull the trigger on a trade. At the bottom of a market, the security isn’t necessarily hated…but virtually ignored. Volume is light, and the major prevailing attitude toward the security is doubt. Even when presented with evidence of strong price action, most investors are uninterested in getting involved. When an idea is working, and the herd isn’t involved, it’s usually a good bet the trend hasn’t yet run its course.

On the other hand, by the time a market has reached the top 20% of its move, the herd has usually picked up the torch, glorifying the trade’s unbridled potential on message boards or in the pages of glossy financial magazines. Volume, once sleepy and intermittent at best, is now significantly higher, and a security that once traded a few thousand shares a day might now do a million or more. By this late date, mutual fund companies and other financial intermediaries are probably just starting to roll out a bevy of new products specifically designed to target that particular sector or asset class, and the general tone amongst investors is that taking a position is safe, with perfectly plausible fundamentals supporting the bull case. When this sort of enthusiasm reigns — while the market’s price action isn’t confirming the crowd’s outlook — is when I run for the exits. The top might not be in. But, chances are, it’s close.

– Originally on Mar 20, 2006 by Jonathan Hoenig

But for the active trader, the notion of diversifying should move beyond simply spreading around your assets to more than a solitary fund. There are a number of smart ways to use a diversified approach that you might have never even considered.

The most basic way to diversify your portfolio is by time. Most people invest as if they were burying a time capsule. They commit their entire risk capital in one day, usually as soon as the check clears or the brokerage account is actually opened. If they have $50,000 on March 1, they invest $50,000 on March 1. Six months later, they dust off their IRA statement from the bottom of a pile of mail and see if there’s any buried treasure to be found.

Bull and bear markets don’t turn on a dime, and just as the ocean is made up of many waves, the market is really a number of smaller markets in varying stages of maturity. It’s not a static still-life, but an ever-changing watercolor that never dries.

And because the investment landscape can shift, you always want to maintain some liquidity in order to capitalize on the next big thing. The point isn’t to always be sitting on cash, but rather to pace the deployment of your assets over time. Today, the market looks strong. A week from now, it might be an entirely different picture altogether. Trading capital shouldn’t come sloshing into the market in an afternoon, but dripped in on an ongoing, continual basis. I picture a portfolio as dead wood being cleared away while mature trades thrive and promising newborns are just being born.

Less obvious, but an even more important way to diversify a portfolio, is by varying the liquidity of the instruments in which you invest. Most trades are disillusioned by a quiet stock. Personally, as I’ve written before, I think less liquid trades are where the best opportunities are often found. A trader’s job is to provide liquidity. As long as a market is acting right, it doesn’t bother me to account for a big part of the daily volume. For example, some of the best utilities trades I was fortunate enough to own over the last two years, names like BIW (BIW) and International Power (IPR), have been rather illiquid stocks. The correct approach isn’t to avoid risk, but to mitigate it by diversifying your exposure.

So when putting money to work, I like to mix up the relative liquidity of my exposure by offsetting one illiquid trade with a trade in a deeper market somewhere else. For example, take the variable-rate preferreds I mentioned late last year. Like most big ideas, this group’s liquidity ranges from names like HSBC USA Inc., Adj Rate Dep Shares Cumul Preferred Stock, Series D (HBA-D) (average daily volume 1,700 shares) to the comparatively active Merrill Lynch & Co. Inc., Floating Rate Dep Shares Noncumul Pfd Stock Series 2 (MER-H), which lately trades well north of 300,000 shares each day. Rather than choose between the two, my approach is to own a piece of both. The idea is to expand the exposure, but do it in a prudent way by varying the liquidity risks of the overall trade.

As I pointed out last week, active markets are vibrant markets, where buyers and sellers can easily hedge or assume any types of risk they choose. And despite a ridiculously inefficient regulatory burden it takes to develop them, the presence of new financial products (and the active investors willing to trade them) has been a major benefit to the stability and growth of markets world-wide. They allow one to diversify by product with an efficiency that was impossible only a few years ago.

And for an active investor, these are absolute boom times for portfolio management. Beyond simply buying stocks, you can tailor exposure using options, futures, and a host of exchange-traded and open-ended funds. And while the best approach is usually the most simple, I do usually opt to own a number of products within one particular idea or theme.

For example, take some of the telecoms I last mentioned a few weeks back as showing some leadership. A long position in Qwest Communications (Q) or Hungarian Telephone & Cable (HTC), for example, might be coupled with an “index” exposure using a security like Vanguard Telecommunication Services VIPERs (VOX) or Telecom HOLDRS Trust (TTH). Or if you’re still waiting for Verizon Communications (VZ) to turn around, you might consider augmenting the trade with an international twist with iShares S&P Global Telecommunications Sector Index Fund (IXP) or Emerging Markets Telecommunications fund (ETF), or selling a put option on AT&T (T). The idea is that you’ve expanded your exposure to the trade but diversified the product used.

An obvious benefit of using this approach is that it can often save your hide if you pick the right race but wrong horse. Too often we end up owning the weakest stock in a sector where everything else seems to jump higher. By adding another equity or even broad index exposure, you “cover your bases” in case your particular pick ends up being the runt of an otherwise winning litter.

Moreover, having two different exposures, even through options or mutual funds, gives you the chance to manage your risk more closely. For example, instead of just owning Barrick Gold (ABX), you might consider adding a position in Goldcorp (GG) or ASA (Bermuda) (ASA) as well. It’s quite likely a rising tide will lift all boasts, and if one trade gets stopped out, you are still “in the game” with the other allocation. This approach often keeps me participating in trades where losses in one particular name would mistakenly prompt me to cut and run altogether.

– Originally on Mar 06, 2006 by Jonathan Hoenig

Unfortunately, the effort to develop new markets in recent years has been severely hampered by the regulatory tentacles of overreaching government. Between Sarbanes-Oxley, the SEC and the Commodity Futures Trading Commission, just to name a few, bureaucratic red tape has slowed innovation even as technology has pushed trade far past the Buttonwood tree. Thankfully, a few pioneers have created exciting new marketplaces in which I see gobs of profit opportunity. These are two of my favorites.

Prosper.com
Prosper.com, a lending marketplace, offers probably the most exciting and innovative development in online dealing since the Iowa Electronic Markets pioneered presidential futures contracts over a decade ago. Here’s why.

Online banks like ING Direct and Bank of Internet have come to offer comparatively higher savings rates thanks to less overhead. Without having to maintain the expense of physical branches, Internet banks are able to offer significantly better returns on savings accounts and CDs. To get a loan, however, you’re still at the mercy of banks’ rather traditional loan departments. In other words, submit your credit information and cross your fingers for a positive outcome. Banks lend money on their terms and their terms alone. The system is closed, uncompetitive and inefficient.

Prosper.com turns that paradigm upside down by running an open marketplace where anybody — from the urban Fat Cat to the rural grandmother — can become a banker. Essentially, Prosper has created a marketplace for unsecured consumer loans that connects those looking to borrow directly to those looking to lend. An individual seeking funding for anything from home repair to a college education creates an online ad, describing the size of the loan he’d like, what interest rate he’d be willing to pay and how he intends to use the money.

The listing in essence sells the loan, and although some borrowers prefer to stay anonymous the smart ones provide email addresses and links to web pages in order to better assuage lenders’ fears. Just as a loan officer at a bank would frown on an applicant who came in wearing unkempt clothing, Prosper.com loan listings with misspelled words or shoddy design don’t receive much attention.

Lenders also evaluate loans based on an applicant’s debt-to-income level as well as a credit rating provided by Experian. (Ratings range from a pristine AA down to HR, or high risk.) Just like a traditional bank, your credit ranking affects the rate at which people are willing to lend you money. Right now on Prosper.com, highly rated borrowers are paying as little as 6% for loans, while those with lower marks are paying 15% or more. The loans are unsecured and all carry a three-year term.

If you don’t need money, but rather have some extra to lend, you can click through pages and pages of loan requests, deciding for yourself what risks you feel comfortable in taking. Amounts range from a few thousand dollars up to $25,000, and you can fund the entire loan yourself or contribute as little as $50. Because a number of lenders band together to fund one loan, you’re able to diversify your exposure. If a high-risk borrower skips payment for a $10,000 loan, you might only be on the hook for $75 of it. Payments are made monthly, and Prosper.com handles all loan servicing for a nominal fee.

Because loans are made through a competitive bidding process, borrowers might find themselves paying less interest than they originally thought. A listing that started at 10%, for example, might end up being made at 8% as Prosper’s community of lenders competitively offers better rates. As volume of business and depth of user base grow, you’ll see bigger loans being made at more competitive rates, benefiting lenders and borrows alike.

HedgeStreet
Another breakthrough market worthy of your page views is HedgeStreet, a small but rapidly growing futures exchange specifically designed for retail (read: small) traders. Less than two years old, the CFTC regulated marketplace’s focus on small, limited-risk contracts is unique. With the exception of the Chicago Mercantile Exchange’s e-Mini futures franchise, most of the recent developments in derivatives trading have sought to attract the big-money hedge players with billions to wager.

HedgeStreet is different. You can open an account with as little as $100, and trading is done directly through a web-based interface with no separate commodity brokerage account required. Two types of contracts are offered, binary options and capped futures. Both are referred to as “Hedgelets.”

Binary options are short-term, small-size bets on any number of underlying instruments including precious metals, currencies, energy and short-term interest rates. Often referred to as “yes-no” contracts, the options pay either $10 or nothing, depending on whether the underlying asset settles above or below the strike price at expiration.

For example, the exchange listed a “Gold > $554.00 (Feb 27 2006)” option, which as of Friday was trading around $7. The underlying asset is the Comex April 2006 future, the strike price for the option is $554.00, and the expiration was today (Monday) at 1:30 p.m. ET.

Since the price of gold stayed above $554, the option paid off at $10 per contract. If the price of gold had fallen below $554, then the option would’ve paid nothing. So assuming you bought the contract at $7, you made $3 because gold stayed above $554. If gold had dropped below $554 by Monday’s close, then you would’ve lost your entire $7.

The exchange also offers “capped futures,” which allow you to potentially profit based on how much an asset rises or falls before the expiration date. Similar to the binary options, the potential loss (or gain) on the capped futures are limited, so you know going into a trade exactly what your potential risk or reward might be.

For example, the exchange is currently trading a “Crude Oil $43.00 to $73.00 (Feb 28 2006) Future,” which as of Friday was trading around $62.91. The underlying asset is the April NYMEX Crude Oil contract and the expiration date is Tuesday at 2:30 p.m. ET.

If you believe the price of crude is going to rise, then you’d buy. Assuming you bought one contract at $62.91, the most you could potentially make would be $10.09, the difference between the price paid and the upper “cap” on the contract. The most you could lose would be $19.91, representing the difference between the price paid and the lower “floor” of $43.00. Knowing many of their target users have never traded futures before, HedgeStreet offers a simple interface that details the potential gain/loss on every trade.

Unique to HedgeStreet, even among the large professional exchanges for now, are contracts based on residential real estate. Using either options or futures, traders can speculate on the price of single-family homes in Chicago, Los Angeles, Miami, New York, San Diego or San Francisco. Think Chicago housing is undervalued? You can get exposure to the asset class without even buying a plane ticket to the Midwest. Or if you’re worried about a drop in the price of your Manhattan walkup, you can sell short a futures contract that will pay off if the East Coast real-estate market tanks.

Last week, the firm received a major vote of confidence in signing a strategic alliance (along with a sizable equity investment) with the Chicago Board Options Exchange, which pioneered listed options trading more than a quarter century ago. The CBOE not only plans to jointly develop new products, but also to market HedgeStreet’s existing contracts as well. You’ll undoubtedly see more liquidity, tighter spreads and even better opportunity in the months to come.

– Originally on Feb 27, 2006 by Jonathan Hoenig

For example, although you’ll never hear this at Wharton or Kellogg, one of the biggest ways investors trip over themselves is through the altogether pointless exercise of trying to determine if a company is “overvalued” or “undervalued.” And while I know the implication is that undervalued stocks will eventually rise as the market discovers their worth and that overvalued stocks are bound to come crashing down, friends, if you want to make money…and that’s your shtick, I can unequivocally promise that you’re barking up the wrong tree.

What this sort of fundamental analysis misses is the obvious reality that a company and its stock are two different entities altogether. The truth is that oftentimes perfectly lousy companies have outrageously bullish stocks. CMGI (CMGI), for example, was $160 back before the company had anywhere near the revenue it enjoys today, when it trades near $1.50 a share. Conversely, it’s not uncommon that a highly profitable firm’s stock is downright moribund for years. Wal-Mart Stores (WMT), for example, is a venerable money machine, yet the stock rests not far from where it did back in 2000.

As is our philosophy here at Tradecraft, the correct way to look at a security isn’t as overvalued or undervalued, but as strong or weak. Strong instruments get funded, weak ones are avoided or cut. It’s really that simple. Warren Buffett would grimace to hear it, but opining on valuation is a parlor game with very little bearing on what actually counts — the stock itself.

The second way a trader should change the way he or she thinks is by getting out of the habit of establishing a “time horizon” for each trade. Bizarrely, some people enter trades with a predetermined amount of time they expect to be in them. Some investments are “short-term trades.” Others they’re confident enough to anticipate holding onto for “the long term.” All told, it’s a fiscally ruinous way to look at the world.

The way to think about trades isn’t in terms of how long they take — but how they act while you’re in ‘em. I go into every trade with the hope of being able to hold onto it for years, but with the humility to know that — regardless if it’s next week or next decade when XYZ drops 20% below my initial purchase price — I’m going to kick XYZ to the curb.

The problem with classifying an investment as being a “short-term trade” is that you’ll inevitably end up leaving the real gravy on the table for no other reason than you were itching to go ahead and make another trade. Imagine if you bought Chicago Mercantile Exchange (CME) back in 2004 at $100 and sold it $50 higher a few months later, just because it was a “short-term trade.” The stock eventually surpassed $400, but you missed it because the reason for dumping shares was totally subjective and without any connection to the price action of the security itself. You can’t let your winners run if you’re constantly turning over your short-term trades.

Conversely, suppose you bought Alcoa (AA) six years ago in the mid-$30s with the intention to hold the stock as a “long-term” investment. Although the stock has been down as much as 40% — and generally has been dead money at best — you’ve held onto this “solid company.” Why? Because you bought it for the “long term,” even though the market never confirmed your deeply held conviction in the company’s shares.

You should absolutely research, evaluate and stress test until you’re blue in the face. But once a position is taken, the disciplined trader lets the market take over and decide how long the trade will be held. Because losers are a fact of life, it’s quite likely many trades will be gone in a few weeks or less. But when you’re patient, others will plod higher, often for several years at a time. You always want to be open to the possibility a trade might be more profitable, and take longer, than you had originally expected.

Finally, as unnatural as it might feel, the experienced trader doesn’t perceive trades as being “safe” or “risky” simply because of the industry or asset class to which they belong. We feel comfortable and secure making “safe” bets, buying widely owned or highly rated picks, yet it’s precisely those situations where the biggest losers usually unfold.

For example, there’s a sense of safety in buying something you’ve seen profiled in glossy finance magazines or talked about at cocktail parties. The problem is, in the market, the more people who’ve already capitalized on an idea, the more risky it actually becomes. For example, the biggest inflow of money came into equity mutual funds in February of 2000, just as the tech bubble was at its peak. By that time, everybody owned the major indexes, making a position seem like a conservative sure thing. Rather than chase popular and widely owned instruments, the independent trader has to be comfortable as a lone voice in the wilderness, avoiding the emotional security that comes with buying the same list of names that everybody already owns.

Moreover, how you perceive an investment will perform usually has no bearing on how a trade actually turns out. For example, during the big bull market in large-cap stocks, the S&P 500 index was often marketed as a “conservative” investment for slow and steady returns. Same thing about Merck (MRK), which for years was perceived as a “safe” pharmaceutical even as it slid from $70 in 2001 down to $30 just four years later.

The truth is that you want to seek out high-risk situations because that’s usually where the real fat profits are found. Most people feel confident knowing that their money is riding on the stock with the best odds, i.e., the best chance of “winning.” Yet the seemingly risky bets usually have the best returns. Assuming you’re using appropriate position size, the actual risk in buying either the “risky” or “safe” stock is actually quite similar. What’s riskier: General Electric (GE) or emerging-markets telecom play Turkcell Iletisim Hizmetleri (TKC)? If you use a reasonably sized trade at a 15% stop loss, the quantifiable risk is actually about the same.

The truth is that what most people think of as good odds are actually lousy odds. In reality, the stock that’s perceived to be “safe” has all of the downside of a “risky” stock with a fraction of the upside. The less you classify investments as “safe” or “risky,” the more you’re able to concentrate on what matters most — how XYZ is acting in the here and now.

Traders don’t just battle the markets, but their own minds and natural instinct. How you trade starts with how you think. And as difficult as it can be, consistent success usually comes not by getting better information, but by thinking about the same information in a slightly better way.

– Originally on Mar 13, 2006 by Jonathan Hoenig

With its infectious groove and pop-country appeal, it’s easy to understand why the song remains a popular tune. And while there’s a big difference between trading and gambling, investors can certainly benefit from the sage advice given throughout the song’s lyrics. Click here to view the song’s entire lyrics.

The story, you’ll recall, involves a young man “on a train bound for nowhere” meeting up with the gambler, a hard drinkin’ and smokin’ legend who scraped a rocky career “out of reading people’s faces.” Although the gambler probably wouldn’t know preferred stock from livestock, many of his tidbits are just as pertinent to corralling the markets as they are the cards.

One of the most memorable lyrics comes toward the beginning of the tune, where the gambler makes it clear that “if you’re gonna play the game, boy, ya gotta learn to play it right.” Indeed, whether it’s gambling or trading, there’s an appropriate way to approach dealing with risk. Gambling, when done in proper fashion, is a methodical, almost automated affair. You always split aces, double down on 11, and follow a mathematical formula for tilting the odds in your favor.

The same applies to trading. From fundamentals to astrology, there are innumerable ways to divine the market. Most influential to your bottom line, however, are a small handful of portfolio-management skills that constitute the “correct” way to trade. Opine all you want on the next move for Google (GOOG) — but it’s the boring stuff, like using consistent position sizes, setting stop-loss targets and maximizing winning trades, that matters most.

So everyday I ask myself: Am I trading with the trend or fighting it? Am I using consistent position sizes or just shooting from the hip? Am I taking losses early or dragging them around like old wine nobody wants? Am I trading products that are appropriate to my account or simply stroking my ego? Am I taking a smart risk or a sucker’s bet? In other words, am I doing the right thing?

Those who typically lose money in the markets usually approach it as a game, armed with “mad money” to burn and a desire for nothing else but quick action. You shouldn’t trade for fun, but for profit. The seasoned player doesn’t invest based on “feel” or going with his “gut”, but sticks with the nuts-and-bolts discipline that best mitigates the inherent uncertainty of markets.

The wisest quip in the song is also one of its least memorable. At the beginning of the second verse, we’re told how “every gambler knows that the secret to survivin’, is knowin’ what to throw away and knowing what to keep.” This overlooked line brilliantly encapsulates how every trader should approach his portfolio.

The public cares about being “right,” not making money, so they inevitably rush from one hot play to the next, desperately trying to land a win. But the gambler — or, in this case, trader — is adept at dealing with the cards he is dealt, not those he wishes or thought would have been dealt.

We analyze the markets to the best of our ability, but nobody knows the future. Ultimately, XYZ is just going to do whatever the heck it damn well pleases. This is the problem with the vast majority of research and market analysis. Because it’s centered on the security — not how to play it — one is left completely in the dark as to how to approach taking a profitable position.

The answer isn’t so much to analyze where the market is heading, but how you will react to any number of possible scenarios. Good traders instinctively know to “throw away” their losers and keep their winners, just as the gambler plays his strong hands and folds the weak ones. If there is a “secret to survival,” that most certainly is it. Yet you’d be surprised how many investors always seem to cut their winners and let their losers run, usually for years at a time.

Finally, one of the smartest pieces of advice comes in the chorus. Both gambling and trading involve the movement of capital, to which the gambler advises “you never count your money when you’re sittin’ at the table…there’ll be time enough for countin’ when the dealin’s done.”

I remember my first job as a clerk for an S&P trader on the floor of the Chicago Mercantile Exchange. Although my boss was a big swinger, often winning or losing tens of thousands of dollars a day, he never referred to dollars, but “ticks” — the minimum price fluctuation of a futures contract. If it was 11 a.m. and he was up 30 or so ticks, we’d head down to the Merc Club to eat lunch and smoke cigarettes for a few hours. If he was down any number of ticks, he’d likely stay in the pit trying to make it back or simply take off for the day and try again tomorrow.

The point is that although the job of a trader is marshalling money, in the emotion of the moment, he must be able to divorce himself from thinking of a portfolio as actual cash. You buy 1000 shares of XYZ at $50 and it goes to $48. While the disciplined trader would be able to cut the two-point loss and move on to a higher-probability trade, the amateur thinks about the reality of seeing $2,000 dollars evaporate. He loses his nerve, hopes for a comeback, and most likely ends up selling much lower — sunk by the inability to stomach even a modest loss that is, in reality, simply an everyday part of the game.

The same goes for gains. When I’m on a hot streak, I find it helpful not to focus so much on how many dollars I’ve made, but the strength and price action of the positions themselves. Just as “counting your money” in a loss can lead to poor decisions, thinking of the actual monetary gain of your winners usually ends up making you a much weaker hand, unable to withstand the natural volatility inherent in almost any publicly traded security. It usually happens like this: You buy 1,000 at $50 and it goes to $55. The stock then falls back to $52, shrinking your $5,000 to a mere $2,000. When it ticks down another 50 cents, you buckle and sell out for a $1,500 win because you didn’t want to see your gains disappear and, heck, “you never go broke taking a profit.”

Of course, the stock ends up bottoming that afternoon, and three days later XYZ is at $60. You should have made $10,000, but because you were so worried about losing the $1,500, the majority of the move was left on the table. Best to focus on the position so as not to be emotionally distracted by the actual dollars involved.

It’s worth noting that, while both the trader and gambler make a profession out of dealing with risk, trading is not gambling. Unlike speculative activity in the financial markets, gambling serves no economic purpose. Risk isn’t transferred from one party to another; it’s simply manufactured out of thin air for a quick thrill. When you trade a stock, bond, option or futures contract, someone is taking the other side of that bet, and, thus, actually playing an intimate role in the functioning of capital markets world-wide. Blackjack occurs between you and Caesar’s Palace. There is no economic benefit or transfer of risk. Worst off, even for the best of players, the odds are always on the house’s side.

– Originally on Feb 13, 2006 by Jonathan Hoenig

Up until fairly recently, evaluating a stock’s price action wasn’t such an easy task. In the old days, exchange employees would write prices onto chalkboards on the trading floor. The information was then manually input into crude reporting systems and eventually spewed out onto small strips of tickertape in brokerage offices around the country.

In the ’60s and ’70s, active traders frequently kept charts by hand, noting prices out of the newspaper and plotting data each night on large sheets of graph paper. One could also order charts or price data through research firms such as CRB, which would “promptly” arrive weeks later. “Day trading” just didn’t exist.

Even as late as the mid-1990s, almost all of the electronic stock data was delayed by 20 minutes or more, making it near-worthless for use in actually responding to a market move. For active investors, quotes were routinely retrieved by either calling your brokers’ 1-800 number or using some “advanced” tools like the QuoTrek FM receiver I used to carry around with me to class during my senior year of college. As you might imagine, the two-foot antenna and rudimentary LCD display were a big hit with the sorority coeds.

Nowadays, the task of monitoring markets has become a lot easier, thanks to the rapid advancement of technology that allows pricing information to be immediately disseminated world-wide. And while I’ve since updated my own system to a new top-of-the-line CQG, even nonprofessional investors have access to more instantaneous price data than they’d ever be able to watch, let alone trade.

So if you’re committed to watching price action, what exactly should you be keeping your eyes on? Historically, a stock’s closing price was the most important. It “printed” in newspapers and was what most market observers actually saw. But as the capital markets have become a truly 24-hour affair, many instruments never really close at all. Stocks are traded “after hours” and “premarket,” often making dramatic moves based on earnings or other fundamental announcements. Volume in these alternative sessions has grown quickly, and for the well-known stocks of the Nasdaq or S&P 500, liquidity is usually sufficient to trade at least a few thousand shares.

I don’t necessarily need to trade after hours, but I do need to know how a stock is moving. If a stock drops precipitously, I want to know how far it falls. If it rallies back, I want to know where it spends most of the session and how much of the gain is recouped.

But more than anything else, I want to see how XYZ acts during the day. I put a lot of emphasis into observing intraday patterns, watching to see how different capital markets respond and move with each other. This often helps illuminate the “quiet” trends that are unfolding but not yet newsworthy enough to be splashed above the fold in The Wall Street Journal.

Some correlations are obvious. For example, gold stocks such as ASA Bermuda (ASA) or Barrick Gold (ABX) tend to be highly correlated with gold prices. The S&P 500 and the Dow are highly correlated, as are the shares of Qualcomm (QCOM) and the Nasdaq 100. When the major market indexes are rallying, you can bet the major components of these indexes, like General Electric (GE), Citigroup (C) or Johnson & Johnson (JNJ), will be strong as well. Because they are the largest issues within the indexes, they are what the arbitrageurs trade to get quick exposure when trading against index futures or ETFs.

But I’m most interested in what other instruments are moving in concert with a strong or weak market — specifically those stocks or sectors that may not necessarily be large components of the major indexes. I believe that intraday, this sort of price action is a terrific indicator into the underlying state of various securities.

For example, I remember that when I owned utilities in recent years, I was always mindful that the group would seem to outperform intraday when the general market was rallying. In fact, after bullishly profiling the sector since the fall of 2004, I wrote about my observation in a May 2005 column entitled “Now That’s Amore”: “I’d swear that when the market does rally, it’s lately been utilities like TXU, FirstEnergy and Allegheny Energy that are leading the way. That type of leadership — even on an intraday basis — is a big part of what I like to see when putting money to work.”

Indeed, utilities were in the midst of a strong trend — one that would see them rise double digits even from May, and see the sector end as one of the best performers of 2005.

And even if names like Black Hills (BKH) and Duke Energy (DUK) weren’t great percentage gainers for the day, the fact that they showed positive price action while the broad market was rallying was my sign they were among the strongest equities on the board. To that end, nonprofessional investors will most certainly want to examine intraday charts after the close to observe what groups were rallying, or lagging, as the broad market happened to rise.

And when I’m intrigued by a particular price action, I don’t hesitate to follow up with additional inquiry to either confirm or dismiss my hypothesis. So, if I happen to notice that AT&T (T) seems to be rallying with the broad market, I’ll follow up by looking at similar issues such as BellSouth (BLS) or Qwest Communications (Q), which are also showing recent strength. I’ll look at the company’s exchange-traded debt such as AT&T ABS Corp Bkd Trust Certs 2001-33, 7.25% (XKJ) or AT&T ABS Corp Bkd Trust Certs 2001-21 , 7.40% (CJO) to confirm they’re also holding up.

In short, I’ll try to become as informed as possible about the state of AT&T’s securities. Because that’s what we trade. That’s what matters. And as much as it might horrify the fundamental analysts, a company’s actual underlying business doesn’t mean a darn thing. Watch the stock. That’s what counts.

– Originally on Feb 06, 2006 by Jonathan Hoenig

Although 2005 was a relatively flat year for the broad stock indexes, there was plenty of upside in foreign stocks, gold, real estate, energy, utilities technology and even industrial names. You simply had to be quick, agile and more active than buying the major markets and holding out on for the long haul.

It’s a wide world out there beyond the Dow or S&P 500, which is why diversifying among strategies makes perfect sense for all portfolios. While manager A is chasing down one area of the capital markets, manager B could be making money using an entirely different approach.

To that end, it’s worth noting that last year, despite constant scapegoating in the press and the looming threat of new government regulations, hedge funds were still able to outperform the S&P 500. The CSFB/Tremont Hedge Fund Index rose by roughly 6% in 2005, surpassing the widely watched S&P 500. Isn’t it odd that while Bill Miller gets lauded on the cover of Barron’s for barely topping the S&P 500, hedge funds beat it handily and all they get is nasty press and more onerous government oversight?

I’ve been supportive of hedge funds for many years and remain so. For even the most conservative investor, investing in a number of different actively managed hedge funds would be ideal. The approach boils down to diversifying among a series of independent, alpha-seeking portfolio managers to achieve superior, risk-adjusted results regardless of the macroeconomic or market climate. Why is that such a shocking concept for Securities and Exchange Commission do-gooders to accept?

As I’ve written before, government regulation eliminates hedge-fund investing for all but the wealthiest accounts. Yet any investor can benefit from adopting a hedge-fund mentality when putting money to work. It doesn’t necessarily mean buying esoteric instruments, using leverage or trading up a storm; rather, it means taking calculated risks, thinking independently and focusing on absolute return.

First off, successful investors pick their points and focus on taking specific risks. There are plenty of times when even a “dangerous” hedge fund might decide to be less than fully invested. Personally, I don’t understand the overwhelming need to be 100% committed to anything, especially stocks. Many of the best trades are the ones you decide not to make.

Yet even among the sophisticated (read: rich) investors with whom I deal there often exists this highly impulsive, gut-driven mentality that cycles between greed and fear. One moment, clients want to be fully invested, either trading on margin or buying into leveraged bull funds from Rydex or Profunds. Days later, they’re either dumping their entire account and putting the proceeds into CDs or withdrawing hundreds in cash from the ATM just to hold hard currency in hand. Like a pendulum, they swing back and forth between these two extremes. Folks, I’ve been there, and I can attest that bouncing between greed and fear is a tiresome and self-destructive way to run money.

Second comes the ability to think independently — not caring what someone else’s positions are or what they might happen to think about yours. Despite the fact I appear regularly on television and opine frequently in the financial press, I’ve always maintained that the best approach for portfolio mangers is “don’t ask, don’t tell.” The more I speak with other investors about the market, the more I’m likely to be influenced or biased by their opinions. The best decisions are those that are solely prejudiced by the market itself.

And while many investors are resigned to hold onto a plummeting XYZ simply because it’s some white-shoed investment bank’s “top pick” for 2006, a hedge-fund mentality is loyal only to protecting the bottom line. I’ve always been of the mind that in the market or in life, pain is the body’s way of telling us that something’s not right. I don’t ignore my losers; I embrace them. It’s that discomfort that’s the motivating force behind taking the loss and getting me out. When that happens — and it happens to everybody — I try and take a breath and reassess what part of my market outlook is flawed. Am I fading the herd or following it?

Thinking independently also means a willingness to trade in new products or lesser-known securities. I can recall how, back in the early 1990s, many investment pros boasted of demanding “NYSE-only” executions. Too bad they were so myopic. While they were waiting for their fills from the floor in New York, the real gravy was being made on Nasdaq and the ECNs. Also, have you noticed how after years of outperformance that investing overseas has come decidedly into vogue? It certainly wasn’t that case back in 2002, which is why it can pay to look beyond the well-beaten path.

Finally, the best embodiment of the hedge-fund mentality is to focus on absolute — and not relative — return. Indeed, almost six years after the Nasdaq collapse, most investors now realize that making 30% doesn’t mean much if you give back 25% of it the following year. Turns out the real money comes not from having one great quarter or picking one week’s top-performing fund, but from being able to repeatedly compound money over time. From a hedge-fund manager’s perspective, beating some index in any given year isn’t as important as consistently achieving absolute (read: positive) return.

And as 2005 fades into history and 2006 just starts getting underway, that’s exactly what you should focus on. In the months ahead, I’ll unpack the strategies, trades and trends I’m using to successfully navigate the market. It’s my honor to have you along for the ride.

– Originally on Jan 09, 2006 by Jonathan Hoenig

Now, years later, the deutsche mark is gone, replaced by a single European currency used by 400 million people in 22 countries. The euro is the world’s most liquid and actively traded currency behind the U.S. dollar. It’s also the benchmark for a new New York Stock Exchange-listed security that I believe is poised to become a huge success.

Three years ago, I heralded the launch of fixed-income exchange-traded funds as a major breakthrough. More recently, I covered gold ETFs as a huge development in portfolio opportunity. Last week, Rydex Investments introduced the Euro Currency Trust (FXE), a currency-based ETF that trades on the NYSE. Although only recently launched, this landmark innovation represents a major victory for capital-market participants world-wide. That’s why it gets my vote as perhaps the best trade of the new year.

Simply put, this new ETF offers an effortless way to bet on (or against) the euro. Trading under ticker symbol FXE, each share represents 100 euros plus accrued interest. If the euro strengthens relative to the U.S. dollar, then the price of FXE will rise. If the euro weakens, then FXE falls. Because euros held in the fund earn interest, the fund also boasts a dividend (although a portion of the yield will be lost to the 0.4% annual fee paid by investors to the fund’s sponsor, Rydex). The ETF can be sold short or bought on margin, with investors paying a brokerage commission to trade it just like any other similar security. Both the prospectus and fact sheet are worth reviewing.

The opening up of foreign exchange to individual investors represents a landmark achievement. The forex market is huge, trading more than $1.8 trillion each day with a quarter of that occurring between the dollar and euro. Yet unlike equities, forex trading occurs “over the counter” with no centralized marketplace. Most transactions range between $5 million and $50 million, making it impossible for all but the biggest players to participate. Spreads and commissions in the opaque “spot” market are also difficult obstacles to profitably overcome.

Currency futures, while exchange traded and more readily accessible to the retail customer, present their own shortcomings, including the need to constantly roll positions forward as contracts expire. FXE, on the other hand, trades on the NYSE and never expires, so it can be held for as long as a trader’s capital allows.

Like the gold and fixed-income ETFs, FXE democratizes an entire asset class that, for the average investor, was almost impossible to directly participate in. In recent years, foreign-bond funds like Templeton Global Income (GIM) and American Century International Bond (BEGBX) have become popular ways to play a weakening U.S. dollar, although those funds presented additional exposures in the forms of credit and interest-rate risk. FXE offers a “pure play” on the euro and makes getting specific exposure as easy as buying shares in General Electric (GE).

Most of us are familiar with the need to diversify our equity and fixed-income portfolios. Yet the difficulty in playing the dollar has kept us from having to think too much about currency risk — the potential that the value of the dollars in your pocket (or bank account) might fall in value relative to other world currencies. And while there are thousands and thousands of mutual funds that own the same handful of large-cap U.S. stocks, this is one of the few products that allows individual investors to diversify into an entire new asset class.

As I wrote a while back, more than stocks, bonds or any other asset, Americans live, think and breathe in dollars. We hold them in our pockets, and in savings and checking accounts. Our paychecks and bills are paid in dollars. So regardless of your view on the economy or President Bush, most of us are “long” dollars in a big way. This new ETF offers an efficient and easy way to diversify that risk.

For the more active investor, I predict the security will likely become a major trading vehicle. It’s already off to a busy start, averaging roughly 400,000 shares traded a day. Even more notable, the market has been incredibly liquid, with five- to 10-cent spreads and markets 50,000 shares deep. If you ask me, it won’t be long before FXE, not unlike StreetTracks Gold Shares (GLD), will be routinely trading a million shares a day.

Although it has recently weakened, much to Warren Buffett’s dismay, the U.S. dollar mounted a strong recovery against the euro in 2005. (One euro currently equals about $1.20.) Regardless of what 2006 has in store, I believe FXE is on the road to becoming the first of a series of widely successful currency-linked ETFs. Unlike the dozens of copy-cat funds mirroring large-cap benchmarks, the security presents investors of every size an effortless entry into a particularly important yet cumbersome corner of the capital market. It is certainly a ticker to watch in the year ahead.

– Originally on Dec 19, 2005 by Jonathan Hoenig

Fundamental analysts would suggest selling a stock when the company’s prospects begin to deteriorate. When the CFO quits, or the new, whiz-bang product fizzles, or if earnings miss expectations, investors should eliminate the holding from their portfolios. It’s a traditional, quaint and money-losing approach.

A company and its stock are two different things. Because it’s the stock that you trade, the company’s performance should be the least influential part of your decision-making process. It’s the stock — and, more specifically, the stock’s position in your portfolio — that should drive the decision-making process.

Also, as we often point out, fundamental news tends to trail price action, not precede it. This is precisely why investing is called speculation. Once the news is out, it’s usually too late for investors to capitalize on it.

So when do you kick an investment to the curb? One time to consider selling is on those few occasions when an investment has grown to become a dominant part of your portfolio — say 10% to 15% percent. However, even at that point, I don’t advocate indiscriminately dumping shares. I’d stagger some stop-loss orders — predetermined levels below a stock’s current price at which the stock is automatically sold — below the market price. With XYZ at $50, for example, I might opt to sell a third of the position at $46.31 and another third at $43.31. This approach allows me to reduce my risk if the stock weakens, yet remain in the trade should the bullish trend continue.

Of course, such an embarrassment of riches isn’t a frequent occurrence. When it comes to selling an investment, you should be more familiar with tossing the losers than the winners.

Thanks to Martha Stewart, most investors have learned about setting stops. Some people use a percentage decline; others use a particular technical indicator. What matters isn’t the particular strategy you use, but that you use a strategy in the first place. No matter how “risky” or “safe” an investment may be, an experienced trader always predetermines and limits potential losses.

Once a position has become legitimately profitable, by a minimum of 10%, the next goal is to make sure that profit doesn’t turn into a loss. The most natural stop order should rest one “round turn” (the cost of two commissions) above your entry price — essentially at a level that would net a breakeven on the overall trade. As a result of my discipline, I’d estimate that as many as 50% of my total trades end up being scratches. While the profits from a winning trade evaporate, the trade itself — the initial capital investment — never becomes an outright loss.

For most investors, the prospect of missing a chance to grab profits isn’t easy to swallow. It’s my belief, however, that the profit itself isn’t as valuable as the winning position. The most powerful, highly probable place to be in the market is to hold an open winning trade. At any given moment, it’s the one asset the vast majority of players don’t have. Most people hold their losers. Over time, that’s a doomed approach.

Every loss hurts. But there’s something about watching a profit turn into a loss that’s especially painful. All traders deal with the continually haunting echo of “coulda, shoulda, woulda.” But the emotional debilitation of watching a 20% winner turn into a 20% loser will throw off even the most disciplined hand. Unfortunately, it’s a lot easier to say “let it ride” once you’re down on the trade and are desperate to believe that shares are simply “oversold.” That’s rarely the case.

But, of course, you should stop a 20% or 30% loss. There’s no more sense in holding onto XYZ after a 35% decline just because you used to own it at a 25% win.

Case in point: Just take a look at how many portfolios still hold Microsoft (MSFT), Lucent Technologies (LU), Time Warner (TWX) and Sun Microsystems (SUNW) — all the washed up growth stocks from the 1995-2000 bull market. While virtually no investors have made money in these stocks in years, they are still in plenty of portfolios, no doubt in part because we remember buying them at such comparatively high prices. They were winning stocks once — so the belief is that they’ll be winning stocks again. And maybe they will be eventually. But traders must focus on the here and now. In order for Sun Microsystems to regain its 2000 high, the stock has to gain more than 1,500%. It might happen, but probably not in my lifetime.

Another nuance I’ve added to my sell technique over the years is to add a time-stop element to profitable trades. Essentially, I tweak my breakeven stop based on the length of time I’ve held the trade, relative to a cash-equivalent benchmark. The longer I hold a trade, the less I’m willing to let a profit slip away.

For example, say I’ve held XYZ for two years, over which time the stock is up 20%. Estimating the risk-free rate at averaging about 3% over the last two years, the absolute latest I’d be out of the trade would be at 6% above my purchase price. This approach ensures that, although I might lose much of a profit on the trade, the return will still end up at least matching the risk-free rate I would have made sitting on the sidelines.

Naturally, your stops get tighter as time moves along. And although you might not necessarily sell the investment, each year that goes by you quietly move another few dollars into the profit pile.

Not only does this protect a gain, but it also helps to keep capital focused on timely trades. If you’ve held a stock for five years that hasn’t moved significantly beyond your purchase price (or stopped you out along the way), you have to begin to question if the original analysis was correct. This trick keeps returns pegged to at least the risk-free rate, and helps to keep capital from going stale in trendless, go-nowhere trades.

– Originally on Nov 14, 2005 by Jonathan Hoenig

The Bush administration’s follies have helped to animate the efforts of political rivals. Consider the misguided and un-American legislation proposed in recent weeks by Senator Chuck Schumer (D., N.Y.).

Schumer has called for a 50% tax on the profits of oil companies, the money being used to help pay for Hurricane Katrina relief as part of a proposal he has dubbed the REPAIR Act, or Recapture Excess Profits and Invest in Relief. According to Schumer, the largest oil conglomerates might reap $80 billion in windfall profits. “If we took half of that, $40 billion, that could go to Katrina relief, and that would be money taxpayers wouldn’t have to pay,” he said at a recent press conference.

This is socialism. In Schumer’s world, profits earned by law-abiding companies are his to confiscate and dole out as he sees fit. Schumer believes it is his right to rob those who’ve earned a living and redistribute the proceeds to those who have not. “Oil companies who are making excessive profits because of Katrina, and perhaps Rita, should, at the very least, shoulder a share of the burden with taxpayers,” he said.

Why? The oil companies didn’t cause the hurricanes, nor did they dissuade people from insuring their homes. The oil companies didn’t force Americans to buy SUVs that get eight miles to the gallon. All Big Oil has done is provide a safe, reliable commodity to millions of Americans, most of whom, unlike Sen. Schumer, understand that prices shouldn’t be set by Congress, but rather by supply and demand.

Economically speaking, it’s obvious why Schumer’s extortion attempt should be laughed out of Congress. There is no such thing as “excess profit.” Oil doesn’t appear magically out of the ground. Major investment and expenditure are required to extract crude oil, turn it into gasoline and deliver it to your local service station. Big Oil makes money, yes, which is reinvested in its business, developing new technologies, improving infrastructure and paying dividends to shareholders.

The moral case for supporting Big Oil is even more compelling. Oil companies are not owned by the federal government. They are owned by their shareholders and run by managers who have the full right to act in its best interest — not in the interest of a publicity-seeking senator.

In a free market, a company has the right to offer goods or services at whatever price it chooses. Consumers can accept or refuse the price. The fact is, oil companies have earned their profits by providing a useful product that many Americans are happily willing to buy, even at $3 a gallon. By way of comparison, a gallon of White Out would cost you about $254.17.

“Katrina has hurt everybody. There’s only one small group that has benefited — the oil companies,” said Schumer, politicking in front of a gas station. “Why shouldn’t they take some of that benefit and return it?” Well, Senator, because they’ve earned it. Did Schumer offer tax breaks in the mid-1990s, when sub-$20-a-barrel crude prompted Big Oil to undergo major retrenchment and belt tightening? Of course not. That sort of thing doesn’t play well in Poughkeepsie.

If he actually wanted to bring down gas prices, perhaps Schumer should take a look at the taxes paid at the pump. According to the American Petroleum Institute, Schumer’s home state of New York boasts the highest gasoline taxes of any state in the union, with 62.9 cents of tax levied on every gallon.

Schumer has decided that not only is a company’s profit subject to confiscation, but so is the private intellectual property that it has spent hundreds of millions of dollars to create. Earlier this month, Schumer called for the temporary suspension of the patent owned by Swiss pharmaceutical company Roche Holdings covering Tamiflu, which fights the avian flu. Roche’s patent on the drug expires in 2016, but by suspending it, Schumer would allow generic drug manufactures to produce the drug, supposedly adding to supply.

Schumer scolded Roche for “putting profits ahead of world safety.” But while Schumer was busy putting out press releases, it was Roche (or Gilead Sciences (GILD), which in 1996 granted Roche the exclusive rights to manufacture and distribute the drug) that made the effort to produce Tamiflu in the first place.

The government’s job is to protect private property — not to confiscate it for the benefit of the so-called public good. Those who take the time and put forth the effort to create life-saving drugs should be free to profit from them. To suspend Roche’s patent simply because it isn’t providing the drug in a manner that suits Schumer is akin to breaking into the company’s bank account and stealing millions. It’s thievery.

This type of maneuver is old hat for the senator. Four years ago, Schumer pulled a similar stunt with Bayer (BAY), which held the patent on the Anthrax-fighting antibiotic Cipro. In the midst of a national paranoia over Anthrax-tainted mail, Schumer tried to suspend Bayer’s patent on the drug, arguing that “one company should not be able to stand in the way of the health needs of a nation.”

The economic rationale against Schumer’s actions are obvious. Why should investors or drug companies spend billions to develop breakthrough treatments if politicians can effectively steal their secrets just as the value begins to rise? Such a policy discourages development, innovation and research. You’ll note the senator hasn’t been in the private sector since 1974. Perhaps he has forgotten that the profit motive doesn’t work without the profit.

More important is his philosophy. Schumer’s proposals run directly counter to the basic capitalist principles on which this country was founded. The Declaration of Independence presents our rights to life, liberty and the pursuit of happiness as unalienable. They can’t be revoked, suspended or struck down by the majority mob.

Yet that’s exactly what Sen. Schumer seems willing to do. Free trade, for him, exists up to the moment he gets antsy for a photo-op. In an effort to bolster his own public image, Schumer targets large corporations who’ve done nothing more than legally provide goods and services to the free market. He does it all with a smile on his face, claiming to serve the “public good.”

His party and constituents should be ashamed.

– Originally on Oct 31, 2005 by Jonathan Hoenig

There are a million different theories on how to employ stop-loss orders. Some recommend a technical indicator, such as placing stops at the 200-day moving average or trendline support. Others use a percentage stop, selling an investment after it falls, say, 20% below the purchase price or a recent high. As with most disciplines, the key isn’t the approach you choose but rather being able to stick with it.

The main complaint I always hear about stops, and why many traders refuse to use them, is that they believe their stops are indiscriminately targeted by specialists. At the New York Stock Exchange, trading is overseen by firms, known as specialists, that make a market in particular stocks. That involves overseeing trading, matching buyers to sellers, and even buying and selling shares themselves when there are order imbalances. Conspiracy theorists — the same people who believe there was a second shooter in the Kennedy assassination or that rapper Tupac Shakur is still alive — suggest that specialists purposely allow markets to drop to levels where stops get hit, only to then allow prices to rally back almost immediately to previous highs.

I don’t buy it. Specialists are an easy target for our anger when we get washed out of a trade, but the truth is they don’t control a stock’s price. Orders to buy and sell securities are constantly being placed in the market. Some traders use stop orders. Others prefer market orders, which can take place between the investor and a specialist, or between two investors.

Naturally, the market tends to gravitate around the biggest — and thus slowest — wolves in the pack. When I was a floor trader at the Chicago Board of Trade, I learned not to try and force the market, just narrow it a little. Whether it was soybeans or Treasury bonds, us “locals” would observe where large public limit orders were placed, and make their markets around the “paper.” The same notion exists in trading stocks, or in any free market for that matter.

For example, if a big institution places an order to buy 20,000 shares of XYZ at $50.25, then the specialist can sure feel confident about bidding $50.27 for a mere hundred shares. Maybe they get filled, maybe not, but either way they’re able to lean on their knowledge of the 20,000-share buy order. There’s no sure thing in the markets, but an order of that size would help support the market if it rallied, and give the specialists a quick way to easily lay off their exposure if prices fell.

So if the market is bid 20,000 shares at $50.25, then specialists will price their bid off the standing limit order. After all, if I could get filled a few hundred shares at $50.27, then perhaps the 20,000-share buy will turn from limit to market and I can scalp them off at $50.40. Or if I buy XYZ at $50.27 and the market starts to fall, then I know there are 20,000 shares being bid just two cents below where I bought them. That’s plenty of liquidity for me to be able to get out with my measly round lot.

The point is that the specialist is there to add liquidity, not to prevent volatility. You can’t rely on the specialist to prevent a drop in price of any stock, especially thinly traded ones. Just because a stock is trading at $50 a share doesn’t mean the specialist should have to buy 10 million shares at $49.99 if the highest public order is at $49.01. The specialist trades around public orders by improving the market, not controlling it.

Markets are unpredictable. If a stock breaks sharply lower and stops me out, then I live with it. And if the stock rallies back and I’m still bullish on the trade, then I’ll usually end up getting back in. Experienced traders know that’s not collusion — just the cost of doing business. After all, similar moves very often occur in Nasdaq stocks, where there’s no specialist at all. (Computers, not people, match buy and sell orders on the Nasdaq.)

The real reason for a stop isn’t to save you a few cents on a trade, but to act as a risk-control mechanism for those occasions when a large trend shift might be underway. With XYZ at $50, I don’t care how promising the company’s prospects might be. Chances are, your stop at $49 is going to hit. Stocks fluctuate; that’s what they do. But with XYZ at $50, a slide to $43.28 — a drop of about 13% — would indicate a greater likelihood that a major trend change is in the process of occurring. If so, then it makes sense to place a stop somewhere around that level.

One technique I use when placing stop orders is to avoid round, or what I think of as “simple,” numbers. In the market, the public tends to generally act as a herd, even when trying to be unique. Plenty of folks, especially the herd that we so desperately seek to avoid, tend to choose the most painfully obvious numbers when setting their stops.

So if XYZ is at $32.22, then they’ll put a stop at $30, or maybe $30.50. Both are big, round numbers. After years of watching stocks gravitate toward those “obvious” prices, I’m downright certain it’s because those are the favorites of lazy, nonprofessional traders. There’s plenty of scholarly research to support the hypothesis. A 2003 study by academics David Ikenberry and James Weston concluded that “investors appear to be naturally drawn to certain prominent numbers when faced with making decisions under general uncertainty.” Their research indicates that, roughly 48% of the time, the last digit of the closing price of U.S. stocks is either “0″ or “5.” It’s just psychologically easier to place orders for $30.00 or $30.25 than $29.93.

When picking the placement of stop orders, my technique is to incorporate a little bit of chance. I start where I’d initially think to set the stop and end up widening it based on a random number. So let’s say XYZ is trading at $32.22, and I wanted to set a 10% stop. Seeking to avoid obvious numbers, I wouldn’t leave my stop at $29.00, even though that would constitute a 10% decline. Rather, $29.00 would become my starting point. But to achieve the exact stop price, I’d literally roll the dice to find two individual random numbers. Let’s say I roll 7 and 1. My new stop would be at $28.71. That’s much less obvious, thus making my trade less likely to be grouped in with the herd’s.

It’s not a foolproof approach, but the truth is that we are creatures of habit. Using a set discipline in strategically setting the stop, yet allowing the final determination to be chosen by a randomizing event, is a unique way of regulating your risk while hopefully steering clear of the slow-moving public.

– Originally on Oct 24, 2005 by Jonathan Hoenig

Why should bulls want to see fear? While it’s uncomfortable to experience, when it comes to stocks fear is a great contrarian indicator. In the market, significant fear usually marks a reversal. By the time we get fearful, it’s usually too late to capitalize on the trend that prompted our concern. So if today’s markets were exhibiting more signs of fright, a bullish argument could be made that the major indexes’ fortunes were close to turning. As I’ll outline in a moment, I have yet to see any indication that’s occurred.

Let’s review a bit of the damage that’s transpired recently. Since the beginning of October, stocks across the board have weakened, quickly slipping from the summer highs that saw the Dow near 10700 and the S&P at 1240. Year-to-date, all major indexes are now firmly in the red, with the S&P 500 down 2%, the Dow off 4.6%, and the Nasdaq 5% lower. Leading the way downward have been many widely held financial stocks, with JP Morgan Chase (JPM) and Bank of America (BAC) both lower more than 10%, and mortgage lender Fannie Mae (FNM) off by more than 35%. Dow 10,000, last nipped in mid-April, once again looks well within the market’s immediate reach.

While stocks have been falling, interest rates, both short and longer term, have made demonstrable progress higher. The five-year Treasury now yields 4.3%, nearing levels not seen since 2002. The yield on the 10-year bond, stuck in a range between 4.0% and 4.5% for more than two years, now appears ready to challenge the upper ceiling of that range. Money-market funds that paid under 1% 18 months ago now yield 3% or more. As I wrote last week, cash is no longer trash.

Bonds of the auto makers, namely Ford Motor (F) and General Motors (GM), have been rocked in recent days, with the yield on their debt now well into the double digits usually reserved for risky banana republics or bankrupt debtors. And we’re still watching the implosion of derivatives broker Refco (RFX), whose bonds now trade at 29 cents on the dollar, and whose market capitalization has dropped by a cool $2 billion in just a week’s time.

Even with recent consolidation, energy prices are still sharply higher year-to-date, and the Reuters CRB index is resting near peaks not seen since the early 1980s. Gold, often cited as a “safe haven” during economic turmoil, isn’t far from 18-year highs.

Indeed, judging from the capital markets there’s plenty of reasons to be fearful. Yet there’s scant evidence that the market has yet really experienced the fright that would prompt one to believe a bullish reversal is underway.

Take, for instance, the CBOE Volatility Index, known as the VIX, the widely followed indicator that, since its introduction in 1993, has come to be known as the “fear gauge.” The VIX measures market expectation of near-term volatility conveyed by stock index option prices. Since 2003, the VIX has been calculated using options on the S&P 500, although the original VIX (still calculated on some trading platforms under symbol VXO) used options on the S&P 100. The principle is still the same: During periods of financial uncertainty, the VIX tends to rise; the greater the fear, the higher the VIX level. Because there’s more data available, for the purposes of illustration, I’ve chosen to look at the original VIX.

From 1997 to 2003, the original VIX rarely dipped below 20 and experienced several spikes above 40, including the Sept. 11, 2001, attacks that prompted a move above 50. Since 2003, however, directionless markets, along with an increased interest in selling option premium, have prompted volatility to drop. This summer, the index dipped below 10, not far from an all-time low. And while fear is up slightly in recent weeks with the original VIX touching 17, from a historical perspective it remains quite low.

The same complacency is evident in technology stocks, as illustrated by even a cursory glance at the CBOE Nasdaq Volatility Index, or VXN. Calculated using the same methodology as the VIX, the VXN represents the implied volatility on the Nasdaq 100, giving traders a quick-glace indication of the fear being priced into tech. Once again, with the VXN near 17 we can see that fear has climbed slightly in recent weeks, but is still nowhere near the 40, 50 and 60 levels seen through most of the early 2000s.

When we get scared, we sell stock. To that end, another fear indicator worth noting is the cash level of equity mutual funds, which gives an immediate snapshot of how fully invested (and thus, bullish) active stock-fund managers happen to be. The data are published monthly by the Investment Company Institute, a mutual-fund industry trade group.

In the mid to late 1980s, the ratio rested in the high single digits, with mutual-fund managers routinely holding 9% to 10% of their portfolios in cash. It peaked at the height of the early 1990s recession, with 11.4% of assets sidelined in cash. In recent years, professionals have held significantly less cash, and besides a bump higher after the 2000 market rout, cash levels have again dropped, now scraping multiyear lows under 4%.

This tells me that, despite the weak markets and worrisome economic indicators, most active mutual-fund managers aren’t yet frightened enough to raise the amount of cash held in their portfolios. It also suggests there isn’t a great deal of buying power waiting in the wings to support stock prices should they continue their recent decline.

And if that doesn’t worry you, well, maybe it should.

– Originally on Oct 17, 2005 by Jonathan Hoenig

There’s always a bull market somewhere in the world. But there are plenty of times when a trader should consider being less than fully invested — that is, to know when not to fight.

At any given moment, even after-hours or overnight, traders consciously decide which risks, if any, they wish to bear. I certainly empathize with owners of Delphi (DPH) stock, Worldcom (MCI) options or Northwest Airlines (NWB) bonds, but let’s not forget there is no constitutional obligation to hold them in a portfolio. Successful traders bet only on situations in which they believe the odds are in their favor. The golden rule: When in doubt, stay out.

The trades you should avoid like the plague are whims, distractions or trades made “for fun.” Friends, don’t trade for fun — trade for money. The positions I put on when I feel bored are almost always guaranteed to wreak havoc on my bottom line.

Because many of us are motivated by the excitement of uncertainty, we naturally end up taking foolish, stupid, low-probability trades. An IPO comes out and we buy a few thousands shares, hoping to ride a point or two of the first-day-pop. Or a reinsurance stock drops after hurricane damage is released and we sell a few puts for amusement and the thrill of making 50 cents on the dead cat bounce. Or the market opens sharply lower, and we buy a couple of e-mini futures in an attempt to jump out as quickly as we jump in. I’ve never had much luck with any of these impulsive, whimsical trades.

*Doubtful Trades*

# Trades made “for fun.”
# Positions held in lieu of cash.
# Poorly sized positions, bad technique.
# Losing positions, regardless of fundamentals.

Every brokerage account in the world comes standard with a cash or money market account in which to hold assets waiting to be invested. Yet even when faced with losing, doubtful or low probability trades, many investors avoid exiting a position simply because they don’t know where to put the proceeds. They are bizarrely uncomfortable with the idea of holding cash because, in their words, their money isn’t “doing anything.”

Unlike milk or bread, money doesn’t go stale if not used within a few weeks. The decision to sell one investment is totally separate from the decision to buy a different one. If it’s time to exit a trade and there are no new opportunities that catch your eye, simply keep the money in cash and wait for greener pastures to appear.

Consider that, even if you got stopped out of your positions in mid-2000 and sat on cash for three years, you would have still outperformed the vast majority of fund managers who fought a bear market because they felt they had to be invested in something. When you can’t find anything that meets your purchase criteria, it’s better to go to the beach than to park your assets in a subpar trade.

Moreover, holding cash has become a lot more palatable lately thanks to the persistent rise of short-term interest rates, which now offer richer yields than the dividends paid by many widely held, large-cap stocks. According to Bankrate.com, the average yield on money market accounts is now 2.26%, roughly double from where rates stood through most of 2004. Shop around to find a high yielding money market mutual fund, and the payouts get even juicier. For example, the Payden Bunker Hill Money Market fund (PBHXX) currently sports a seven-day effective yield of 3.46%, almost a full percentage point higher than the dividend yield on General Electric (GE). The Vanguard Prime Money fund (VMMXX) isn’t far behind with a 3.44% current yield, roughly 2.5% greater than the annual dividend being paid by IBM (IBM). For the first time in a long time, cash ain’t trash.

When buying XYZ, a little nervousness is healthy. But if I’m doubtful about the way I’m buying it — if I can objectively say the trade is recklessly sized or weighted — I’m much more apt to move to the sidelines quickly and reassess the situation. For example, you might feel skittish in buying shares of streetTRACKS Gold Shares (GLD) — after all, gold has had a huge run lately and could be seen as overbought. What should prompt doubt, however, isn’t necessarily the stock, but your position in it. Are you trading a 5% position, or 15%? Are you using a “mental stop” or a real one? Are you making a bet, or betting the farm? Traders who over-leverage or under-diversify their portfolio will face eventual ruin, no matter how savvy their stock picking might be.

Finally, as I always point out, the best indicators come from the market itself. Nothing should raise your level of doubt in a particular trade as much as how it’s acting once you’re in it. Generally speaking, it’s the losers that should be escorted to the door.

Yet when the fundamentals are bright and the analysts are cheery, many investors are content to hold on to loses month after month, even though the price action isn’t confirming their investment hypothesis. Bottom line? Projections and analysts are often wrong, but the market never lies.

If you’re bullish on XYZ, fine, be bullish and buy XYZ. But harbor some doubt about your timing. When the market isn’t confirming my bullish outlook, I’m inclined to find a way to exit the position. Losses prompt doubt. And doubt gets me out.

– Originally on Oct 10, 2005 by Jonathan Hoenig

There was a time in the 1990s when the thought of investing in anything other than Cisco Systems (CSCO), Microsoft (MSFT) or the major U.S. markets would’ve seemed downright daffy. Foreign stocks? Commodities? Small caps? Who needed ‘em when Sun Microsystems (SUNW) and the S&P 500 went up a tidy 20% every couple of months.

But in the markets, change is the only constant. And while American shares have long been the locomotive that pulled the world’s train along, lately they’ve been more like the caboose. Right now, the market seems to be showing a preference for most anything besides U.S. stocks. Because equity markets are the best gauge of economic growth that we’ve got, this underperformance bodes ill for both America and its currency.

The biggest fear most people have when putting money into a market is a dramatic, 1987-style crash. It’s a largely irrational fear: The Nasdaq didn’t go from 5000 to 1130 overnight, nor did Nikkei. It took roughly 14 years for the Japanese market to drop from 39000 to 7600, while the rest of the world, especially the U.S., steadily passed it by. U.S. markets aren’t plummeting, it’s true, but the truth is that it’s the slow, trendless markets that are usually even more dangerous than the massive one-day drops.

And while American shares have been largely stagnant this year, world-wide shares are leading the charge higher. The Dow, Nasdaq and S&P 500 are anywhere from 10% to 58% off their record peaks. Meanwhile, stocks all over the world — in New Zealand, Australia, South Africa, Vietnam, Saudi Arabia, Brazil, South Korea and India — are at or near their all-time highs. You can’t just write off stocks as a weak asset class nowadays. The fact is that equities in general do have a bid. The only problem is they don’t have bid here in America.

Stocks are hot, but so are hard assets, which doesn’t bode particularly well for the dollar, of which we’ve grown very accustomed to being a strong and secure store of value. Along with the widely reported record prices in oil and natural gas, various metals have also shot higher lately. Copper and platinum, for instance, aren’t far off from record highs and gold, bullishly profiled in this space last month, has now outpaced the Dow by a cool 11% year-to-date. Gold has usually been thought of as a novelty or diversification, but talk to someone who’s lived through currency devaluation, and they’ll swear by it as their core holding.

And what of U.S. stocks? While energy shares continue their bull run, many other widely owned domestic names appear downright sick. Fannie Mae (FNM) and Freddie Mac (FRE), along with every mortgage REIT under the sun, look like death — not a huge vote of confidence in the housing boom that’s helped propel the economy forward in recent years. Several Dow components like DuPont (DD), International Paper (IP) and Wal-Mart Stores (WMT), names you’d expect to prosper in the face of economic growth, are instead plumbing multiyear lows. It’s the same story for many bank stocks. Bank of America (BAC) and JP Morgan Chase (JPM), two widely owned benchmarks, have lost much of their oomph lately. The most successful domestic plays have come from betting on a few winning sectors like utilities and energy, or by using option-writing programs that benefit from flat or trendless markets. Considering how many other equity markets are sharply higher, that’s not exactly a major vote of confidence in the good ol’ US of A.

How to approach such an uncertain market? As I wrote last week, before taking new positions, the best course is to deal with the ones you already have. And when it comes to existing, winning positions, your instinct should always be to preserve gains rather than take them. Stocks discussed in this space that I hold at a gain, such as Warner Music Group (WMG) and MarketAxess (MKTX) will be kept. Same goes for my positions in several utilities, especially the international ones like Brazil’s CPFL Energia (CPL) and Chile’s Enersis (ENI).

In addition, I’ve added exposure to a few areas that, despite the last of a clear fundamental story, appear to be on the verge of showing new leadership. The metals boom has benefited gold and copper shares such as Glamis Gold (GLG), Goldcorp (GG) and Freeport McMoRan Copper & Gold (FCX), so I’m again dipping my toe back into the palladium market. Regular readers will recall that the white metal was a winning trade a couple of years back, and if current trends persist, palladium operators like Stillwater Mining (SWC) and North American Palladium (PAL) could end up big winners again. Of course, the usual bevy of risk factors, including lack of liquidity, should be considered before putting money to work.

I love this country dearly. But despite my devout patriotism, I’m objectively ready to accept the notion that, for whatever reason, the U.S. might not be the economic leader in the future that it has been in the past. Just as we couldn’t think of sending our money overseas in the 1990s, in this century, we might not imagine doing otherwise. If the commodities boom ends up a harbinger for a weak U.S. dollar, then holding metals plays like StreetTracks Gold Trust (GLD) or iShares Comex Gold (IAU) might become as common as Time Warner (TWX) or General Electric (GE).

The point is that everything is on the table. Successful traders should keep their eyes open, their heads down, and be ready to expect the unexpected.

– Originally on Oct 03, 2005 by Jonathan Hoenig

Getting out of a trade, especially at a loss, can be an enormously difficult trigger to pull. Equally thorny is simply standing pat and having the patience to let the market move unfold. Yet knowing when to hold ‘em and when to fold ‘em forms the basic framework on which successful portfolio management is built.

Forget Sharpe ratios and exotic options techniques. In trading, there’s nothing new under the sun. The golden rule — cut your losers and let your winners run — hasn’t changed since the beginning of time. And when following up on a trade, that’s precisely the philosophy that you should engage. Winners are preserved. Losers get kicked to the curb. End of story.

I moved quite a bit of money around this summer, so it’s worth following up on some recent columns to best illustrate how, even in this brave new world, the old saws still apply.

While I had high hopes for getting back in the saddle, right now it appears my return to floating-rate funds was a bit premature. Despite their monthly dividends and compelling fundamental story, I must be objective enough to admit that the price action has weakened. Trades that were once green with profit are now bathed in red.

That’s the only indicator I need to prompt me to make a change. Because while the investment hypothesis is still intact, it’s the market that should influence trades. Whether it’s Enron’s implosion or the dollar’s decline, the story almost only comes out after the real move has been made. For now, I’ve once again left most of my positions in this asset class behind.

Of course, taking a loss hurts. And if not approached with the proper perspective, the emotional toil of dealing with a loser can derail an entire investment program. For years, after selling a loser, I’d beat myself up, questioning how I could’ve been so stupid as to buy XYZ right before a precipitous decline. And it’s at those moments, when morale is weakened, that trading discipline can easily go straight down the tubes. Because we want to be right, because we want to win, our ego can’t stand the reality that, at least this time around, we’re wrong.

In a frantic gasp to “get even,” we recklessly double down or start day-trading the Nasdaq 100 (QQQQ) — anything to avoid dealing with the painful reality that we lost money on the trade. Friends, I’ve been down that road, and I promise you that it ends only in even more severe — usually cataclysmic — losses.

So instead of chastising yourself for having a loser, it’s a heck of a lot more productive — and profitable — to simply take the loss, remove the ticker from your trading screen, and move on to another idea. Every wrecked portfolio started with a small loss and a stubborn trader who just had to be right.

While not every trade will be a winner, put enough lures in the water and eventually you’ll get a bite. Thankfully, I’ve had a few, with most of the other ideas I’ve put forth lately having fared much better than the unprofitable foray into floating-rate funds. Gold bullion, which I bought into in August, is up roughly 5%. And of the three recent initial public offerings that I profiled a month back — MarketAxess Holdings (MKTX), Warner Music Group (WMG) and Stonemor Partners (STON) — two are in the winner’s column so far. MarketAxess has climbed 30% since Aug. 22, and Warner is up more than 6%. Stonemor, like the S&P 500 index, has traded flat over the past month.

And how am I following up the winning positions? As a trader, what am I doing to maximize my profit potential? Nothing. I’m doing absolutely nothing at all.

I’m not selling covered calls or scalping around the trades. I’m not taking a quick profit and planning to buy back the positions a few bucks lower. I’m not scouring the message boards or Securities and Exchange Commission filings looking for a reason to jump ship.

The quiet secret of investment success is that too often the best move is no move at all. When you have a winner on, it’s usually just sitting on your hands and having the patience to let a trade run its course that produces the best results.

Yet letting the winners run can be even more difficult than cutting the losers. As traders, we’re anxious to win. We crave success. And there’s nothing as satisfying as taking a position, watching it climb and then making the cash register ring. The feeling puts sex and drugs to shame.

But provided it hasn’t grown to dominate your overall portfolio, the proper way to follow up a winning trade is to let it be. Just as taking a loss stops a loss from growing, taking a profit kills a portfolio’s profit engine right in its tracks. Just consider how many people sold Microsoft (MSFT), Cisco Systems (CSCO), Sun Microsystems (SUNW) or CMGI (CMGI) during their growth spurts because they had made a nice 15% to 20% profit, only to watch the stocks spiral skyward by thousands of percent?

The old lessons are still the best. And after taking a position I follow up by worrying about the losers — usually finding a way to cut them short and move on. The winners I try and leave well enough alone. They tend to take care of themselves.

Investing is a messy affair, with even the best ideas and most well-conceived trades often not working out. Every trader has the occasional loser; the successful ones are those disciplined enough to follow the rules. Clip the losers and allow winning trades to run, and over time you’ll make money. And while both the professional and the amateur know the rules, it’s the pro who actually follows them. That’s precisely what makes him the pro.

– Originally on Sep 26, 2005 by Jonathan Hoenig

After all the debris, sewage, waste and wreckage is cleaned up, a good chunk of the $100 billion rebuilding effort will go toward the region’s infrastructure, much of which was demolished in the hurricane and subsequent flooding.

Infrastructure businesses are the skeletons of economic activity, the essential things we use everyday but don’t think much about. Generally, they’re assets where a natural or near-natural monopoly exists, such as a toll road or power grid. Parking lots, water utilities, roads and airports, even cellphone towers are all considered infrastructure assets.

The appeal of infrastructure investment is obvious. High barriers to entry make direct competition difficult to impossible. Imagine the cost of building a new airport to compete with an existing one. Plus, the assets are all physical and localized — you can’t outsource a toll road to India, or use the Internet to offer cut-rate pricing on a gas pipeline. This makes infrastructure assets much less susceptible to the natural competition faced in almost every other industry.

Because infrastructure assets are economic necessities, have highly predictable revenue streams and require huge capital expenditures to build, they can provide excellent long-term income with reasonably low volatility. Although infrastructure assets are usually highly regulated, user fees for businesses such as toll roads or airport parking can be raised, making the asset class comparatively well-insulated from inflation.

In recent years, in almost every country besides the U.S., there has been a trend of government privatization of big-ticket infrastructure assets. In the U.S., however, most infrastructure assets are still owned by government-related entities. LaGuardia Airport, for example, is owned and operated by the Port Authority of New York and New Jersey. In contrast, Auckland Airport, New Zealand’s largest, is owned by a public company that’s actively traded on the New Zealand stock exchange. American investors, therefore, are relatively unaccustomed to the notion that, from toll roads to hydroelectric dams, large infrastructure assets can be attractive investment vehicles.

The international leader in infrastructure investments is Macquarie Bank, a fast-growing, $10 billion Australian company that has almost single-handedly spearheaded a major market expansion of infrastructure as an asset class. Typically, Macquarie buys a collection of infrastructure investments, bundles them into a fund, and sells them to yield-hungry investors anxious for predictable dividends and stable returns.

A few examples of its funds include the A$7.1 billion Macquarie Infrastructure Group (ASX: MIG), one of the largest private developers of toll roads in the world with 12 of them across six countries. Macquarie Airports (ASX: MAP), also listed in Australia, owns interests in airports in Sydney (Australia), Rome (Italy), Copenhagen (Denmark), Birmingham and Bristol (both U.K.). Macquarie Communications (ASX: MCG) invests in communications infrastructure such as satellites, broadcast and wireless towers. Shares have risen more than 50% during the past 12 months.

Unfortunately, the vast majority of the firm’s infrastructure funds trade only in Australia, making them essentially unavailable for U.S. investors. Only three of the bank’s vehicles are directly listed in the U.S. Despite the recently renewed strength in U.S. equity markets, savvy traders — especially those focused on income — might consider including them as part of a diversified, global portfolio.

When we first profiled the Macquarie/First Trust Global Infrastructure/Utilities Dividend and Income fund (MFD) last fall, the fund traded at a cavernous 12% discount to its underlying net-asset value. Since that time, the discount has been cut to around 8%, with shares rising some 20%.

True to its name, the fund invests primarily in utilities and pipelines, both of which have been exceptionally strong amid an environment of rising energy prices. Foreign assets are emphasized, with less than 10% of the fund’s holdings domiciled in the U.S. Many holdings, such as the U.K.’s AWG plc and Kelda Group plc, are unavailable to U.S. investors as American depositary receipts.

Also benefiting the portfolio: a 26% allocation to senior secured loans, an asset class in which I re-established positions last July, along with Canadian income trusts like Northland Power Income fund (NPIFF) and the Consumer’s Waterheater Income fund (TSX: CWI.UN), which have responded favorably to higher commodity prices. At a recent $23.21, the fund sports a yield of 5.69%.

For a true pure-play on infrastructure assets, U.S. investors should consider Macquarie Infrastructure (MIC), a trust that owns a diversified group of infrastructure businesses world-wide. Launched in December 2004, the company pays quarterly dividends and currently sports a yield of 7.08%. Like other infrastructure assets, MIC tends to be uncorrelated to major U.S. stock indexes, making it an ideal diversification for portfolios heavy on equities and short on income.

Among the company’s assets are a 50% interest in Yorkshire Link, a 19-mile highway in England, and Macquarie Parking, which, with more than 32,000 spaces, is the largest provider of off-airport parking in the U.S. Other holdings include Thermal Chicago, which operates the country’s largest district cooling system, a British water utility and a position in the aforementioned Macquarie Communications Infrastructure Group, which owns 600 transmission sites located across Australia. Still expanding, the company announced plans last month to acquire 100% of Hawaii Gas Utility, the island’s only full-service gas energy company, for $238 million.

The Macquarie Global Infrastructure Total Return fund (MGU), a newly organized closed-end fund trading on the New York Stock Exchange, came public less than a month ago. According to the prospectus, the majority of the fund’s assets are to be invested in the publicly traded securities of global infrastructure assets, with up to 15% of assets being pledged to unlisted infrastructure securities. In an effort to increase total return, the fund can also write call options against existing positions to generate premium income, a strategy that has worked well in recent, relatively trendless markets.

I’m bullish on infrastructure. But given the fact that MGU hasn’t yet disclosed its portfolio or dividend, I’d call this one to watch rather than one to run out and buy. ETFconnect.com, run by Nuveen Investments, remains the web’s best source for detailed information on closed-end funds.

– Originally on Sep 12, 2005 by Jonathan Hoenig

Trading, however, is one of the few activities in which more is not always better. If you want to make money, trading more positions more frequently and with more leverage is hardly a stellar strategy. The opposite — fewer positions, fewer trades, less leverage — often yields considerably better results.

Today’s international markets trade around the clock, offering more opportunity than one individual would ever be able to capitalize on. But what many investors, especially the most competitive, often forget is that to be successful, one need not master the market, but only catch some of its waves along the way.

In our fantasy we buy every bottom and sell every top, but here in the real world, it’s the middle 60%, not the bottom and top 20%, where the real money is made. Some people like to think that returns can be improved by trying to milk a trade to the last drop. In my experience, however, results improved dramatically once I began to focus on grabbing a big fat chunk out of the middle — avoiding a trade’s early and late stages.

Because the big money is made on the big moves, it’s the most dominant trends that offer investors the highest probability of success. A 10% pop in Taser International (TASR) or CMGI (CMGI) might warrant a bulletin on Briefing.com, but it doesn’t do much for your bottom line unless you’ve already established a sizable position. A real bull market, where valuations significantly expand, offers the best chance to grab a meaningful return. Big trends, in fact, often give you several opportunities to make money.

So even if you missed the “original” Internet bubble back in 1995, from roughly 1996 to 2000, you could have owned anything remotely tech-related and made money. From software to peripherals, communications equipment to semiconductors — all of them had their day. More recently, we’ve seen how the bull market in energy prices has benefited the entire field of related companies, from master limited partnerships to utilities.

The point is that, in order to make money, you needn’t catch every bottom or sell every top — it’s the middle 60% of a trend where the real money is made. By focusing on dominant trends in major bull markets, you can put the probability of success squarely on your side.

It’s a major falsehood that the more you invest, the more you make. In reality, it often makes perfect sense to be less than fully committed. Like an actor between movies, sometimes there’s simply nothing for a trader to do but wait. When you feel yourself stretching for investment ideas, the best step is to sit on your hands.

Of course, it’s easy to get distracted. And with an overload of stock market information, many traders, like caged parakeets, are drawn to make instinctual “buy, sell or hold” calls for almost any stock under the sun. From Freddie Mac (FRE) to Freeport McMoran (MCX), Citigroup (C) to China Yuchai (CYD), they have an opinion and comment on every investment on the board.

I don’t have opinions — I have positions. Because traders can’t have bets on everything, they must focus attention on only what they believe to be the highest-probability trades available. At any given time, I have a small list of perhaps three to six ideas that I’m observing or carrying out. Excess cash stays in cash.

As I wrote last year, cash, like gold, seems to inspire all-or-nothing thinking. People are either leveraged to the hilt in the Energy Select SPDR (XLE) or completely in cash with nary a stock in sight. Worse off, they begin making sell decisions based solely on whether they’ve got an appealing new trade. So they buy XYZ at 30 and it falls to 25, but they hesitate in getting out. Why? Because they don’t have any clue where they’d put the proceeds from their sale.

Finally, when it comes making money, you’re best served not by trying to target big returns but by limiting large losses. The most unfashionable secret on Wall Street is how substantial profit can be achieved not from one great trade or stock pick, but from consistent compound interest — what Benjamin Franklin called the “eighth wonder of the world.”

It’s a fact that money, when allowed to compound over time, will grow exponentially even at moderate levels of return. The trick is to keep the losses small, because drawdowns not only sap your capital, but also waste the irreplaceable time over which your money is able to multiply.

To that end, one has to cringe on behalf of investors in mutual funds whose long-term track records offer astonishingly dismal returns. Take, for example, the USAA Growth Fund (USAAX), a $933 million portfolio often recommend by financial advisers as a core holding. The fund’s 4.7% return year-to-date soundly beats major indexes. But shareholders aiming to compound their money over time have achieved less success. Over the past 10 years, the fund’s annualized return shrinks to 32%.

It’s a similar story for the Phoenix Capital Growth Fund (PHGRX), a $623 million fund whose inception dates back to the late 1960s. Year-to-date, the fund has nearly broken even, but large losses over the years have made substantial compounding practically impossible. And while its web site cautions that an investment is “appropriate for long-term investors who seek capital appreciation and can accept the higher risk associated with investing in the stock market,” one can’t help but note that the unmanaged Dow Jones Industrials are up roughly 130% over the past 10 years, yet Phoenix Capital Growth’s annual average return over the same period doesn’t even break 15%.

So don’t focus on targeting an upside return — limit the potential for catastrophic, double-digit loss. Lose 10% of your portfolio, and you’ll need only an 11% gain to recover. But a 25% or 30% drawdown of your entire portfolio’s value creates a mathematical abyss from which it’s exceedingly difficult to recover. A 35% loss, for example, would require an almost 54% return to get back to even. Given the uncertainty of capital markets, that’s a mountain investors big and small should avoid being compelled to climb.

– Originally on Aug 16, 2005 by Jonathan Hoenig

Emotions are not tools of cognition. So in managing a portfolio, you can’t act solely on what you feel; rather, you have to act based on what you think about what you observe. Save the tears and anger for a therapy session after the market closes.

As a young clerk at the Chicago Mercantile Exchange, I was always impressed with how, no matter what his profits and losses looked like for the day, the “local” I worked for was able to maintain the same, dispassionate demeanor in the pit. Regardless if he was up 50 ticks or severely in the hole, his disposition never changed. Beyond his market sense, an integral part of his professional skill was being able to ride the emotional highs and lows. This guy would make $30,000 in an hour and not even crack a smile, or be down more than double that and barely break a sweat.

Off the floor, many large trading firms now employ automated, or so-called black box, investing systems. Strategists input parameters for buying and selling into a computer and turn the microprocessors loose on the market. While I don’t use such an approach myself, I am cognizant that we as individual traders must be equally disciplined, emotionally cold and unwavering in both good and bad times.

Sometimes it seems as if we have the golden touch. From small caps to large caps, mutual funds to bonds, everything on the board starts moving our way. Profits are generous, and the high is intense. And when the money is flying in, it’s our emotion that dupes us into believing the good times will never end. (Note to self: They always do.) Through the fantasy haze of a convertible Mercedes or new plasma TV bought with a stock-market score, we often miss the forest for the trees.

And when a big idea comes along and really pays off, we too often end up falling in love. Regardless if it’s gold, bonds or even utilities, we become emotionally attached to what are, in reality, slips of paper we’ll never even see.

So don’t personify stocks; objectify them. A stock shouldn’t be your spouse, your buddy or your friend. You’re in a business and investments are your merchandise. Keep them on the shelves as long as they sell, but once the product stops moving, mark it down and get it out the door. As I’ve written before, I keep a pile of worthless stock certificates on my desk to remind myself that no investment is too sacred not to one day be kicked to the curb.

One way to avoid getting emotionally involved with winning trades is to focus on ticker symbols and prices only — end of story. I know far too many investors who wouldn’t dream of selling Apple Computer (AAPL) simply because they have an emotional connection to their iPods. Intellectually, we all know that a stock and a company are two different things. I also try to avoid annual-report conference calls with management, or anything else that might emotionally tie me into one particular name.

Of course, we mustn’t only learn to manage our emotions during profitable periods, but during those all too often times when the losses far outweigh the gains.

As I’ve written before, there’s no pain like the pain of losing money in the market. The inescapable pangs of sadness, self-loathing and rage are among the rawest emotions you’ll ever feel. But in the market, emotions are a liability. And when you’re losing money, they can become very costly.

Shortly put, you have to keep your cool. Emotional outbursts obscure the fact that losses are a normal and regular part of any trader’s routine. No one likes them, yet we must learn to deal with them. Getting emotional only makes a tough problem worse.

I’ve seen it before. Getting emotional when you lose is often accompanied by self-destructiveness, with traders punishing themselves through reckless trading, alcoholism, drug abuse and even violence. Indeed, the market doesn’t hang us. We do it to ourselves when we get so emotionally vested in any one stock or trade.

If a loss is such a psychologically devastating and unholy occurrence as to require a temper tantrum, then how rationally do you suppose we approach it in our portfolio? Indeed, emotions make your trading discipline disappear. So when you buy XYZ at 50 and it falls to 42, instead of walking away it’s our emotions that persuade us to double down, sell options or start day-trading the Nasdaq-100 Trust (QQQQ). We can’t stand the pain of being wrong, so we insist on being right. And nobody is right all of the time.

Alternatively, the self-loathing that comes with having made a bad decision in the market prompts many people to avoid taking a loss. So they bought XYZ at 50 and it falls to 42, but instead of walking away they hold on, stubbornly ready to go down with the ship. Even if you bought Pets.com, Exodus, Enron, WorldCom and Adelphia at their all-time peaks, provided you had a sell discipline you wouldn’t have ended up riding them all the way into the toilet. Emotions remove that self-control and sacrifice that constraint.

So start by consciously separating the emotion from the cognition. The fact we feel strongly about a stock, having researched the fundamentals, listened to the conference call and read the annual report, doesn’t determine how the trade plays out at all. Duke Energy (DUK) isn’t going to be affected one bit by how many staplers I chuck or garbage cans I kick.

What should guide our approach to XYZ isn’t how we feel about it, but how it’s acting. So once the trade is made, I don’t inquire as to every analyst’s opinion or even closely follow the company’s news. I’m in the position, my risk is defined, and the rest is up to the market and out of my control. To get angry and emotional just because a stock didn’t go my way is a complete waste of time and energy. I must add that it’s also rather uncouth.

Emotions, in both good times and bad, can wreak havoc on a portfolio. Emotions don’t shape your judgment, they distort it. Experienced traders, therefore, are skilled at not only observing investments, but distancing themselves from caring too deeply about them. And by smoothing out the emotional highs and lows, you’re more easily able to keep a portfolio on course in both calm and choppy waters.

– Originally on Aug 01, 2005 by Jonathan Hoenig

And although I’ve bought my share of sour stocks, once in a while I’m fortunate enough to come up with a few winners as well. While I’d love every investment to show a profit, you only need a handful of smart ideas each year to put together a respectable return.

So far this year, one of my best-performing trades has been in utilities, a sector that’s shown exceptional strength since I started pounding the table last fall. As regular readers, along with those who watch me on Fox News Channel’s “Cashin’ In”, can attest, this has long been a favored sector, one in which I’ve been able to experience the best kind of success — that which you can spend.

And while finding winners is difficult enough, managing them is oftentimes even more challenging. Once you’re fortunate to have one, you’re immediately faced with the conundrum of just what to do with it. In my case, I’m confronted with the winner’s curse: Should I pull the plug on my beloved utilities, or take a risk by holding on to them with the hope of even more electrifying returns?

Probably the hardest element of managing a winning trade is simply having the gumption to stay in it. Grabbing a profit, especially a generous one, achieved over a relatively brief period of time is extremely tempting. But as I’ve often pointed out, it’s the losers, not the winners, that should be routinely cut from a portfolio. It takes time, effort and money to establish a winning position. Once you’ve got one, don’t be foolish enough to quickly trade it away.

To that end, I believe the worst strategy in dealing with winning trades is to sell them too soon. Yet I often hear from investors who make it a point to dump investments simply because they’ve hit targets 30% above the purchase price. To me, that’s downright asinine. Just think of all the traders who sold Microsoft (MSFT) or Sun Microsystems (SUNW) in 1996 for no other reason than because they’d booked a good profit. How many thousands of basis points were left on the table just because investors were overanxious to hear the cash register ring?

Even more common is the downright bizarre practice of “portfolio rebalancing,” in which losing allocations are methodically bought and winning trades are sold. This approach, popular with many financial planners, is a recipe for underperformance because it systematically replaces strong allocations with weak ones — all in the name of diversification. Considering the market doesn’t “know” where you got in, why trade away big positions in stocks that have the wind at their backs? That’s precisely where the gravy is made.

So the most notable way to deal with a winning trade is to do your darndest to stay with it, riding the gains for as much of the move as possible. And when a big bet does pan out, you’ll find that small trades grow to become a dominating influence on your overall portfolio. For me, that’s occurred in big-cap utilities like Duke Energy (DUK), Allegheny Energy (AYE), Exelon (EXC), Southern (SO) and California Water Services Group (CWT). Trades that started as 2% to 3% of my fund have appreciated, in some cases, to encompass 6% or more. It’s a problem most of us would be happy to have.

Instead of dumping winning trades just because they’ve grown, I’ll instead start to diversify the portfolio’s risk by deliberately fishing in other pastures besides utilities. Existing trades aren’t abandoned, but assigned specific stop-loss levels. New money can be directed toward different types of investments.

For example, with all the bad news surrounding hedge funds that trade convertible bonds, I’ve begun looking for value in this volatile and relatively underowned asset class. For individual investors, I believe funds remain the best way to achieve exposure. Closed-end choices such as TCW Convertible Securities fund (CVT), Advent Claymore Convertible Securities & Income fund (AVK), Nuveen Preferred and Convertible Income fund (JPC) and Ellsworth Convertible Growth and Income fund (ECF) all boast attractive dividend yields and trade at a discount to their underlying net asset values. This is an appealing new area for me in which I’m just beginning to put money to work.

Also, amid all of the anxiety last week surrounding terrorist bombings in London and damage from Hurricane Dennis, it’s worth noting that smaller-capitalization stocks continued their outperformance, with the Russell 2000 index notching a new all-time high. So if you were heavy into large-cap utilities, diverting new money toward smaller-cap names in other sectors would keep your skin in the game while spreading the risk.

As I’ve written before, it makes sense not only to follow the market but also the slow-moving herd, whose arrival almost always heralds a trade’s imminent unraveling. If you’re making money, then it’s never too long before the crowd shows up wanting to hop on for the ride. Once that process has begun, it’s usually an ideal time to begin to move on from the trade.

While we can graph price action and economic fundamentals down to the decimal point, evaluating public perception (a.k.a., the herd) is a much more difficult and subtle process. Amid the strong performance for utilities, I wait each week for the Barron’s cover story or the BusinessWeek feature article touting the red-hot gains. When that finally happens, it will likely serve as an excellent point to begin paring back positions. Case in point was a recent Newsweek cover story on the falling dollar, which ironically turned out to be a great moment to go long the greenback.

At the moment, however, it appears the public is still more indifferent than indulgent when it comes to investing in most utilities. Right now, the group appears to inhabit an investment no-man’s land: too expensive for the value investors, yet not flashy enough for growth players. I don’t see the trend in utilities reversing just yet, and with winning positions already established, I’m content to hold on for the ride.

In the market, when you’re on a roll you sure as heck better sop up the gains while you can, because the good times never last. Unless you learn to exploit winners fully, there’s really no sense in unearthing them in the first place.

– Originally on Jul 11, 2005 by Jonathan Hoenig

Consider that both planter and money manager need to periodically prune away dead wood. Beautiful gardens aren’t simply grown, they’re continuously clipped and shaped. To raise a healthy garden, experienced horticulturists will rotate crops, clip old foliage and manage the sun. It’s not just about planting the seeds, but tending to the crop along the way.

Same goes for the market, where investment success doesn’t end with simply picking a stock. Ever wonder why most analysts are lousy traders? It turns out there’s a big difference between evaluating an investment and profitably guiding a portfolio. Call me crazy, but in my world there’s more to it than just buy, sell or hold.

We all have losing trades. Professional investors, however, get quite adapt at not dragging them around for years on end. Dead wood won’t sink a portfolio, but will make it significantly less efficient and, over time, less profitable as well.

When clipping my holdings, I always start by looking at the big losers, those positions in which I’m severely underwater by 20% or more. More often than not, these trades tend to be underbrush you’d be well served to simply chop away. As I’ve pointed out over the years, waiting for a huge loser to “come back” tends to be the wrong move. Mathematically, the odds just aren’t in your court. For a 30% loser to get back to even, it must gain more than 42%. Possible? Perhaps. But most likely it’s less probable than taking the loss and moving on to a new, more promising trade. If you’re dragging around old remnants of trades gone bad, either get out now or at least set some stops to get out. That way you can redirect resources toward more timely trades.

Another possibility to prune comes in managing what I call “worthless” positions, the insignificantly sized trades that make up less than 1% of an overall portfolio. The problem with such tiny investments is that, rise or fall, they won’t have any major effect on the bottom line. Yet in every $100,000 portfolio, I always see those $700 positions in Sirius Satellite Radio (SIRI) or Taser International (TASR). Just consider that an investment that size could double, yet it wouldn’t even amount to a 1% increase in your portfolio value. The capital such tiny trades waste isn’t worth the minimum amount of amusement they provide.

So make it a point to regularly review your holdings, paying close attention to the smallest allocations. Positions that amount to less than 1% of overall assets should either be tossed or, if you still favor the trade, bulked up. As I’ve often pointed out, dumping several worthless positions often allows you to cobble together a sizable trade that might actually benefit your bottom line.

Even beginning farmers know there’s a finite period in which any particular crop can be successfully raised. And while I love green beans and think zucchini is one heck of a vegetable, I also know that neither will grow when there’s snow on the ground. So while you would never think to plant tomatoes in November, most people insist on buying stocks at what I believe to be the exact wrong time. Despite all the analysis and hard work, the odds for profitability are stacked against them from the start, simply because they were buying stocks out of season.

As regular readers know, it’s my belief that markets — just like the weather — aren’t chaotic, but rather move in trends that tend to persist over time. Because raising a garden depends on planting seeds at the right time, investors are well served by determining if potential purchases are in season before they buy.

With crude oil hitting new all-time highs, one can’t help but take note of the bull market in energy stocks over the past few years. At a time in which many investors have complained of a lackluster market, the truth is that you could’ve owned almost anything energy-related since 2002 and made money. From pipelines and energy trusts to utilities and even Big Oil plays, a rising tide of crude prices has indeed lifted all boats. This has been energy’s “season,” and investors have had an odds-rich environment in which to participate.

A similar period occurred from 1996 to 2000, when almost any technology stock would’ve earned you money. For several years while tech was in season, the active investor had more than a few chances to make a buck.

And because the best indicator of the market is the market, you’ll be well served by waiting until your favorite stock finds some bids before you take a position. Experienced traders know they don’t have to buy the bottom or sell the top, just be nimble enough to grab a portion of the 60% move in the middle. For my money, it’s always best to wait until an investment shows some element of strength before plunging in with both feet.

Upon finding success in growing carrots, the enterprising farmer might try his skill at onions as well. By closely observing his crop and being responsive to how it behaves, he’s better able to help it thrive. Winning plants should get the water, or at least your attention. If your fern likes being sung to or you find a deep soaking does wonders for your rutabagas, well, hey, whatever it takes.

The point is that in the markets, we learn from observation. Most of our time managing money isn’t spent placing trades but watching how the market changes, acts and responds. I find the most successful traders aren’t those reading annual reports or listening to conference calls, but monitoring what actually counts: their positions in the market itself.

By doing so, I’m often lead back to trades in which I’ve already found early success. For example, recent profits in utilities and real estate have led me to a closed-end fund that focuses solely on those two sectors. Cohen & Steers REIT and Utility Income fund (RTU) sports a 7.28% dividend yield, trades at a 15% discount to its net-asset value, and holds increasingly valuable large caps like Equity Office Properties (EOP), Southern (SO) and Consolidated Edison (ED).

Or upon collecting profits in energy trusts like San Juan Basin Royalty Trust (SJT) or BP Prudhoe Bay Royalty Trust (BPT), the opportunistic trader might focus his bet while diversifying his holdings through one of the recently launched funds that owns the sector. Kayne Anderson MLP (KYN) is a closed-end fund that holds positions in several master limited partnerships, or MLPs, such as Plains All American Pipeline (PAA), Ferrellgas Partners (FGP) and Inergy LP (NRGY). (MLPs are actively managed, publicly traded partnerships that are especially prevalent in the energy sector.) The Kayne Anderson MLP fund trades at a slight premium to its net-asset value, and at current prices it pays a quarterly dividend of around 6.30%. Fiduciary/Claymore MLP Opportunity fund (FMO) holds a similar basket of names, but trades at a slight discount to its net-asset value.

The point is to take your cues from observations made in the market, not in a classroom or line item in a company’s 10-K. And to harvest the best crop, it never hurts to start by watering the plants you already have.

– Originally on Jun 20, 2005 by Jonathan Hoenig

At the heart of this hysteria is a complete ignorance of what hedge funds really are, both among the regulators who oversee them and the financial media that have, in recent weeks, whipped up a panic about how hedge funds threaten to disrupt financial markets world-wide. So let’s start by simply defining the term: A hedge fund is a pool of money pledged by “accredited” (read: rich) investors and managed by a general partner. While most people assume that hedge funds trade frequently and make big bets on financial esoterica, the truth is a hedge fund is a legal structure, not an investment technique.

So while the media routinely characterize hedge funds as “risky” or “highly leveraged,” the reality is hedge fund strategies, just like mutual fund strategies, run the gamut from the ultra-conservative to the highly volatile. Some funds use high levels of leverage, others sit in cash for months at a time. Some employ complex spread trades, while others simply buy and sell stocks. Just knowing someone runs a hedge fund tells you absolutely nothing about how it’s run. What matters are the strategies, positions and discipline that the manager uses to maximize the money.

Yet that reality hasn’t stopped one of the more ignorant perspectives regarding hedge funds from spreading like wildfire. Thanks to the negative media coverage, there now exists the notion that hedge funds are ticking time bombs, recklessly leveraged and dangerously allocated portfolios just teetering on the verge of throwing international markets into a near meltdown.

It’s a perspective that’s fueled by a new breed of sloppy journalism that makes Newsweek magazine’s Koran desecration story look like the Oxford English Dictionary. Business reporters now attribute just about any financial occurrence to those pesky and uncontrolled hedge funds. Oil prices high? Must be the hedge funds cornering crude. Tech stocks falling? Must be the hedge funds selling them short. They’ve become a convenient media scapegoat for every market move.

Most recently, it was the carnage in General Motors (GM) that was falsely attributed to hedge funds’ influence. And while many funds certainly lost money trading GM’s equity and debt, so did thousands of other investors, ranging from institutional pension accounts hedged with derivatives to Midwestern Ma and Pa Kettle’s 100 shares of common stock. And despite the fact that the size of assets controlled by hedge funds is still dwarfed by those controlled by mutual funds and other investors, the press has become quite comfortable with attributing every market maelstrom to this woefully misrepresented group. Because hedge funds are required under Securities and Exchange Commission regulation to keep a low profile (more on that in a moment), they are never able to clearly respond and silence the rumor, innuendo and gossip that now passes for legitimate reporting.

Another major point the fear mongers have focused on in recent weeks is the notion that hedge funds are somehow unregulated. While this is untrue, the inaccurate perception nevertheless fuels conspiracy theorists who claim that a secret cabal of investors is always behind the scenes pulling the markets’ strings. The fact is that hedge funds are exceedingly regulated. SEC rules limit those who may invest to wealthy investors. And while mutual funds and brokers spend billions of dollars a year on advertising, hedge funds aren’t allowed to promote or publicly solicit business in any fashion. Can you think of any other industry that is subject to such Orwellian constraints?

Naturally, because hedge funds aren’t permitted to promote themselves, the only time one ends up hearing about them is on the infrequent occasion when something goes wrong. While the vast majority of the thousands of hedge funds out there are run by hard-working, honest and ethical people, the press only reports on the few bad apples.

The truth is that the real loss of capital over the past few years hasn’t come from hedge funds, which have outperformed the market, but from SEC-regulated investments. On the corporate side, you’ll remember that Enron, WorldCom and Adelphia were all highly regulated firms. And among investors, just consider how many trillions of dollars were squandered thanks to the recommendations, trading and money-management skills of SEC-regulated mutual funds and investment advisers.

Try to keep in mind that hedge funds aren’t run by lawless bandits who, if not for federal regulators, would screw every investor out of their last dime. They are governed, as every one of us is, by the rule of law that prohibits violating individual rights. When cheating, fraud or financial impropriety exists, the law protects investors and offers legal recourse.

What the market needs isn’t more hedge fund regulation, but more openness. By lifting the public solicitation restrictions that keep hedge funds in the shadows, the investing public would be better informed of how the industry’s risks and opportunities compare with other investment options.

No doubt the cynical media will continue to suggest that hedge funds’ activities hurt investors large and small. Participants in hedge funds, so the argument goes, are being taken by the industry’s supposedly unreasonably high fees. Non-participants are hurt by their reckless and market-moving trading. Both suggestions are patently incorrect.

Despite all the hissing about hedge funds’ high costs, the truth is that they’ve been worth it, outperforming almost every other asset class. Since December 1993, for example, the CSFB/Tremont Hedge Fund Index has bested the S&P 500, the Russell 2000 and the MSCI World Dollar index.

More recently, hedge funds actually made money in May, according to both Standard & Poor’s and Hennessee Group, a research and consulting firm that tracks hedge fund performance. So despite all the negative smear pieces in the press, all the concerned lawmakers who’ve whipped up fear regarding the danger of hedge funds and all the calls for increased regulation, the truth of the matter is that hedge funds are, once again, outperforming the rest of the pack. As of June 1, Hennessee pegs year-to-date hedge fund performance at -0.27%, while S&P estimates a loss of -0.42%. That’s better than the 1.98% loss for the Dow Jones Industrials, the 0.98% decline for the S&P 500 and the 4.66% drop in the Nasdaq Composite.

It turns out hedge funds aren’t conniving fraudsters or market manipulators, but hardworking, opportunistic investors simply trying to make a buck. Look beyond the hysteria and you’ll see that while not every fund has made money they’ve generally provided investors with superior risk-adjusted results. And even beyond benefiting their investors, hedge fund activities have behooved the general public by adding liquidity to the marketplace, helping to ensure that investors of every size can assume or lay off risk at will. Far from disruptive, their influence is steadying, taking risks and entering markets that less adventurous investors would likely avoid. That’s the real story the mainstream press has yet to tell.

– Originally on Jun 13, 2005 by Jonathan Hoenig

For most active traders, margin is the best first choice for stretching their dollars. But as I wrote last summer, debt should be limited to high-probability trades, and not to try and pull a half point out of the Nasdaq-100 Trust (QQQQ) or take a flier on some bulletin-board tout. I’m apt to only use margin to add to a position of strength; that is, to support a winning trade in a dominant market trend.

Let’s say, for example, that I’m holding a profitable position in Equity Office Properties (EOP). With real-estate investment trusts continuing higher in today’s market environment, I’d readily use margin to buy a unit of Simon Property Group (SPG), which would diversify the winning exposure but keep capital focused on a major, timely trend.

But even using margin, you’ll inevitably hit a point where you’re looking to make an investment your capital just won’t support. So when it’s time to start making trades, do yourself a favor and get rid of the losers first. Even in a generally profitable portfolio, if you comb through the basement you’ll likely find a name or two that’s bleeding and below water. That’s the trash to be pitched first.

Human instinct will lead you to “shave” a few shares off your big winners and let the losers ride. It’s a tempting approach, but unequivocally the wrong move. Nobody knows the future, but it’s my belief that over time losing trades tend to stay losing trades. And because I believe buying El Paso Electric (EE) puts me in a much stronger position that continuing to hold a 25% loss in Evergreen Solar (ESLR), I won’t hesitate to reallocate that capital.

If you worry about the losers, the winners take care of themselves. And although it hurts to take a loss, you’re essentially buying the benefit of a tax deduction, usually a more valuable asset than an unprofitable open trade. So start with the losers, selling first those positions with the biggest percentage declines, then the smallest positions, and finally the least liquid stocks. Shaving off a portfolio’s dead wood will often generate enough fresh capital to move toward even more profitable heights.

Now let’s say you’ve sold all your losers, but you still need fresh capital. Before I dump a real winner, I’ll often use a conservative option technique and sell covered calls on a portion of existing profitable trades. For example, rather than cash in the gains on my positions in large-cap utilities like Duke Energy (DUK), Southern (SO) and Exelon (EXC), I’d sell slightly out-of-the-money call options on a portion of each name. In exchange for agreeing to sell those shares at a higher price, I’m able to generate enough premium to fund a few entirely new positions. Should the sector’s strength continue, I’d look to buy back the calls or roll them into higher strike prices and future expiration months. Cumbersome? A bit. But it’s still a preferable way of raising capital than simply dumping a winning trade.

If options just aren’t your style, or for other reasons you’re pressed to sell a winning position, my suggestion would be to sell the weakest first. If I have a 10%-15% winner that, over the course of the past few months has shrunk down to a 4%-6% winner, that’s where I’d start. Shave off some of those shares to generate fresh capital.

Also, when choosing between open winning trades, my preference would be to sell the most liquid instruments first. As I often point out, a trader makes money by providing liquidity to a speculative situation. If you’re in the enviable position of holding a winning trade in a comparatively illiquid name, then let it be. The better move would be to dump a winning trade in Microsoft (MSFT), SBC Communications (SBC) or some other actively traded name. Not only can you get back in much more easily and cheaply, but your market sales are less likely to push the price lower, a common occurrence with less-liquid names.

– Originally on Jun 06, 2005 by Jonathan Hoenig

And while I’m never totally confident in my market outlook, I’m usually quite comfortable with my position in the market. Unlike the Nasdaq or S&P 500, which will rise and fall regardless of what I do, I actually have control over how my money is dispersed. So instead of focusing on making predictions, a smart trader should first concentrate on managing his portfolio. The market’s inherent uncertainty can be mitigated by a prudent, disciplined approach.

In the biggest sense, position refers to the financial foundation on which an investment portfolio is built. That’s why portfolio planning needs to start before the first buy order is ever placed. You can’t make wise bets on the market if you’re being distracted by unemployment, debt, an unsustainable lifestyle or other serious financial setbacks.

Take credit cards. I’m always mystified by people who put money into investments while they’re still revolving a hefty balance to Visa or American Express. Who can be comfortable hoping to make 10% in stocks — and that’s on a pretax basis — while carrying credit-card debt at 18% interest? It doesn’t make sense.

And regardless of how savvy of a stock picker you might be, putting money into even “conservative” investments when your financial house is in disarray will end up a losing trade. As I’ve said many times over the years, traders must be able to take small losses as part of the regular routine of disciplined investing. If you’re overextended and playing with anything other than risk capital, then you’re much more likely to make irrational and emotionally driven decisions; namely, holding on to weak and low-probability trades. The strongest and most confident traders are those who know that almost any market malady, from a few bad months to a 9/11-style plummet, won’t have a material impact on their standards of living.

Of course, just as a financial foundation can be made more comfortable, so can a portfolio itself. I’m always anxious over what the next move for stocks might be. However, I sleep better knowing that at any given moment I’m only putting new money to work in what I believe to be the highest probability trades.

While it seems painfully obvious, you’d be surprised at how many people shoot themselves in the foot by wasting precious capital on impulsive, “fun” trades that serve as nothing more than expensive amusements. Amid a few winning ideas, they’re burning capital playing penny stocks or trying to grab a point out of General Motors (GM), Delta Air Lines (DAL) or whatever other news story happens to be above the fold in The Wall Street Journal.

As I like to point out, trading is about making decisions. Because you can’t bet on everything, limiting new purchases to ideas that meet your strict criteria, be it technical or fundamental, gives you the confidence to know that every drop of capital is being most efficiently deployed. I feel comfortable knowing that at any given time, my fund’s assets are pledged only to my best ideas — even if they don’t always work out.

The market will always be uncertain. Through our portfolios, however, we’re able to tweak positions as events unfold to tip the odds in our favor. What makes me feel comfortable in my holdings is the knowledge that every investment I buy has a specific level at which I’d bite the bullet and take a nominal loss.

Most any discipline works as long as you’re able to stick with it. So even if you’re resigned to sell any investment at, say, 20% below the purchase price, you suddenly make the most volatile foreign utility no more “risky” than a government bond. Putting that sell discipline in place right from the start makes dealing with the uncertainty of markets a much more comfortable affair. I’m able to place my bets and, in effect, let the market decide which trades are worth keeping and which should be kicked to the curb.

In this game, there’s no sure thing. We can’t control the market, only the size and nature of our exposure to it. And while I’m never terribly confident in predicting the market, I do feel comfortable as long as I keep my portfolio on a prudent and disciplined path. And if you use risk capital to make smart, focused bets with predefined risk parameters already in place, then you’ll undoubtedly find yourself not only a more comfortable trader but a more profitable one as well.

– Originally on May 23, 2005 by Jonathan Hoenig

Why? Well, as longtime readers know it’s my belief that markets aren’t chaotic, but rather they move in trends that tend to persist over time. So while I can’t precisely predict the future, I can observe the present and make calculated guesses about how securities are likely to respond.

Weak stocks tend to stay weak, or at least weaker than stronger alternatives. After a sharp decline, XYZ might indeed enjoy a dead-cat bounce, but all too often that’s the signal the trade’s gravy has already been mopped up. In my experience, very rarely does an investment break 20% lower because it’s intent on marching right back to previous highs.

So when XYZ cracks, smart traders should move to the side, preserve capital and reassess the forecast on market conditions. This is especially true when a decline in XYZ prompts a position to reverse from being held as a win to a loss. That alone is enough reason to get out of the trade.

One of the more memorable breakdowns occurred in good ol’ Microsoft (MSFT), which, like most tech stocks in March 2000, began deteriorating from all-time highs. Shares gapped from the mid-50s to the mid-40s overnight — a painful move for those long the stock. The real carnage, however, has occurred in the following years. The stock has continued a slow but steady unraveling that has made it dead money at best.

For a more recent example, there’s eBay (EBAY), the ubiquitous online auctioneer whose stock enjoyed a hearty renaissance over the past few years. In mid-January, however, that momentum was abruptly cut short when shares broke from the mid-50s to the mid-40s overnight. That was the smoke, the weakness in the stock indicating the company was no longer the equity leader it had been. And as is often the case in such scenarios, the stock’s initial weakness was the indicator to jump ship. Shares meandered in the mid-40s before sinking to the low 30s just a few weeks later.

Or take IBM (IBM), whose shares dropped from almost 100 to near 85 over the first few months of 2005. After the stock gapped from the mid- to low 80s in mid-April, it proceeded not to quickly recover to the early 2005 highs but to tread water and, eventually, drop another 10%. Even if you’d gotten out after the gap downward, it would’ve been better than hoping for a bounce back to higher prices.

Why run for the hills when an investment suffers a large break? Because while many often think rabid selling is what prompts a stock to suffer a precipitous drop, all too often it’s the lack of buying interest that’s really to blame. As I first wrote back in 2002, the law of supply and demand is also that of demand and supply. While most commentators are quick to interpret a market trend as the result of some action of investors, it’s often their inaction that’s ultimately responsible for the move.

So when XYZ drops 20%, it’s not the presence of sellers but the absence of buyers that causes such a sharp move. Considering that nobody has yet dumped the stock, why not be among the first in line to get out? This is why stop orders, even when triggered below a specified price, are a good idea. When the break does come, at least you’re at the top of the list to get your shares sold.

Of course, as with most elements of trading, that’s usually easier said than done. All too often, our egos prevent sound trading technique. After all, we bought XYZ because we thought it was going higher. To sell it after a loss, especially such a quick one, is both hurtful and humiliating. Just remember that taking a loss is the same as stopping it. Don’t make the mistake of thinking a paper loss isn’t a loss just because you haven’t seen fit to realize it yet.

The other main obstacle that usually prevents investors from exiting a position is the natural but misguided need to understand the fundamental reason behind the move. When a stock breaks downward, instead of running to the exits many often hold off until they know exactly what caused the drop. And as the price plummets, time is wasted combing the message boards, company press releases and SEC filings seeking what amounts to trivia.

It doesn’t matter why a stock moves, only how it moves. A good trader’s responsibility isn’t to explain a market drop but to be able to react to it in a calm and disciplined fashion. So when the air-raid siren sounds, don’t hesitate to run for cover. More often than not, a stock’s first big plummet signals the time to move on.

– Originally on May 16, 2005 by Jonathan Hoenig

Investors can use the idea of ballast to their benefit. Portfolios large and small should be grounded by conservative asset allocation and governed by a prudent approach, not to increase the speed of returns but to smooth the ride. When done well, adding ballast can help you boost your returns and keep you from getting seasick along the way.

Most people’s biggest investment is their home, which makes an ideal foundation for investment stability. You have to live somewhere, after all, and in most cases, buying a home you can afford is preferable to renting, regardless of where real estate prices are.

Did you catch the caveat? A home you can afford. Because while you might consider your home an asset, chances are it’s actually a liability — a rather large one. And while nobody knows for sure whether there’s a bubble in property prices right now, I can say with no uncertainty that there’s an abundance of exceptionally foolish investors taking risks in real estate they’ll no doubt live to regret.

In real estate, as with all investments, size kills. Owning a home you can afford is a smart investment and terrific portfolio ballast. The “no money down” crowd, however — those who’ve leveraged themselves to the hilt with interest-only loans on highly speculative situations — are begging for trouble. Ballast like that won’t steady your finances — it’ll sink them to a watery grave.

If you have an extra $10,000 burning a hole in your pocket, I’d advise using it to pay down your mortgage rather than to speculate in stocks. The market will always be a crapshoot, but paying down a mortgage is a guaranteed return that, even at today’s historically low rates, is virtually impossible to beat.

Cash, or more specifically savings, is another integral element of adding ballast to a portfolio. People don’t do much saving anymore. But in a simpler time, before 401(k) plans and hair-trigger trading, surplus funds weren’t put at risk, but rather into the bank. For most folks, especially those now used to a wallet full of credit cards and payday loans, this would be a great habit to develop.

Before you yelp for a stock tip, why not start with an “emergency fund” — at least six months of livings expenses tucked into a savings account or government-insured CD? It’s amazing how few individuals have accomplished this goal.

If you’re used to having your mood and self-worth dictated by the Dow Jones Industrial Average, you’ll undoubtedly find, as I have, that savings provides your portfolio will both ballast and piece of mind. The psychological benefit of having money far eclipses anything material you could buy with it. And while it’s a terribly unexciting goal when compared with writing options or short-selling stocks, the security that comes with salting away a few months of living expenses can’t be quantified. Life is better when you pull yourself back from the edge.

A final idea for adding ballast to your portfolio is to go for the gold. I’m the first to admit that precious metals, in which I have been previously heavily involved over the years, have recently lost their sparkle entirely. Years ago, these were major market leaders. Now they’ve become the weakest things on the board.

Yet I still believe that precious metals play an important role in a diversified portfolio. Gold is nobody’s debt, promise or obligation. Long before Sirius Satellite Radio (SIRI) and Petrokazakhstan (PKZ) ruled the herd’s portfolios, gold was money. Gold and silver are the only investments I know of that are mentioned in the Bible, and I’m certain they’ll have value thousands of years from now. That’s one long-term bet I’m willing to make.

Whenever I have a bad day in the market and no paper investments go my way, I find deep satisfaction in holding a gold coin in my hand and knowing, regardless of the market’s zigs and zags, that I own a hard asset that will store value over time. Hold an ounce of gold in your hand and you’ll quickly see what I mean. Think of it as pacifier for stock junkies.

One challenge an investor could shoot for would be to accumulate one ounce of gold for every year of their age. A 35-year-old investor, therefore, would need to have accumulated 35 ounces of gold — worth a cool $15,000 at today’s prices — solely for the purpose of long-term savings. While I prefer buying physical bullion, the newly launched Street Tracks Gold Trust (GLD: 56.14, 0.00, 0.0%) exchange-traded fund also makes an excellent choice for accomplishing this allocation.

Adding ballast can present significant challenges for people. But I believe it’s a smart endeavor for sophisticated investors looking to anchor their portfolios amid a turbulent market sea.

– Originally on May 09, 2005 by Jonathan Hoenig

So although Bill Miller is still heralded as one of the best portfolio managers around, he too was pummeled by the brutal bear market. An investment in his Legg Mason Value Trust (LMVTX) dropped some 40% from 2000 through early 2003.

Or take legendary portfolio manager Stanley Druckenmiller. In early 2000 he left George Soros’ Quantum Fund after bad technology bets erased almost $3 billion — more than 20% of the hedge fund’s assets.

Even Warren Buffett, the Oracle of Omaha who is lionized as the world’s greatest investor, has stumbled from time to time. From the summer of 1998 through early 2000, an investment in his beloved Berkshire Hathaway (BRK.A) fell by almost 50%.

Because it’s not a matter of if you’ll experience a losing streak but rather when, what really counts is the way you handle it. All traders stumble now and again. The trick is knowing how to pick yourself back up off the mat.

To say that losing money hurts is an understatement. In fact, it’s often difficult for those who don’t trade to fully comprehend the anguish and despair that come along with a drawdown in your account. The inescapable pangs of sadness, the uncontrollable inner rage and personal pain are among the rawest emotions you’ll ever feel.

And while we’ve all experienced disappointment and sadness before, unique to the pain of investment losses is the immense self-loathing that comes along in knowing that it was our own actions that precipitated the pain. Nobody forces us to take a position or make a trade. When we lose, we do it to ourselves and have no one else to blame.

It’s that reality that leads us to antagonizing self-examination in the hours and days following a market loss. Even after years as a professional trader, I can’t tell you how many times I’ve buried my face in my hands, thinking that had I only sold XYZ earlier or bought less of ABC I would’ve avoided my market misfortune.

But while the market might trip us, it’s usually our own loss of discipline that slits our throats. And after a series of losses, one of the most common and financially dangerous reactions is to quickly try and reverse the damage. Because the pain of accepting a loss is so great, many traders will resort to reckless technique in an attempt to make up the difference. Simply put, they get completely out of control.

Like the compulsive gambler who can’t help but bet the farm, a trader in the midst of utter desperation tends to throw out proper technique altogether. If he usually trades 100 shares at a clip, then he’ll start betting 1,000. If he’d always held investments for a big move, then he’ll start playing for the two-point pops. While he’d previously held a diversified portfolio, he’ll begin betting the ranch on just one or two sectors.

Problems are magnified if despondent traders turn to substance abuse. It’s a phenomenon I first observed as a clerk on the floor of a major Chicago commodities exchange. Consider that if alcohol lowers inhibitions in a bar, just think of the damage it can do to you while trading. You’re down 10%, slightly tipsy and desperate to make it up. So why sell short 50 shares when you’ve got the margin for 5,000? Or why bother waiting for some puny dividend-paying stock to move when there’s a penny stock on the pink sheets that’s bound to rise or fall double-digits before lunchtime. My advice: Just say no.

Rationally, we know that losses are part of the game, and that all investors, from time to time, experience disappointing declines. But the trader mentality is a competitive one that wants to win. Because our profit/loss statement is what we use to keep score, the best traders get used to separating their net worth from their self-worth.

As painful as it might be to lose money, you must be able to maintain composure and confidence even in the midst of a bad run. In the market, money will always come and go. Lose your discipline, however, and you’ll never see another dime. When losses come, you must think of them as part of the trading game, not a personality flaw.

One of the best ways to ensure you don’t fall off the wagon, even during a rash of heartbreaking losses, is to only take chances with risk capital. The market is stressful enough, and as I wrote a few years back, the best way to maintain discipline is knowing that it’s risk capital — not a mortgage check or tuition payment — that’s on the line. The only smart risks are those you can afford to take, and you’ll never be able to make rational decisions when your pride and paycheck are both on the line.

During a drawdown, I’ve also found it useful to reduce my risk and re-evaluate the market with a fresh perspective not influenced by my previous positions. So instead of berating yourself about why you didn’t dump XYZ in time, take the loss, take a break and come back to your portfolio with a youthful and unbiased view. Losses will always be part of trading. How we cope with them is what sets the professional trader apart from the pack.

– Originally on Mar 28, 2005 by Jonathan Hoenig

Yet market fantasies can ruin a portfolio when allowed to overwhelm a trader’s rational faculties. Following a script can be dangerous. What’s important is to have a general belief of how a market might move, not a detailed description of XYZ Inc.’s every tick.

For example, oftentimes people are intent on earning a profit in a specific stock. They’re not merely interested in XYZ — they’re downright married to it. They construct detailed industry analysis and earnings forecasts. They read countless research reports and newsletter recommendations. They draw trendlines, set price targets and take up shop as resident know-it-alls on the Internet message boards. XYZ is their world, till death do they part.

Of course, somewhere in the middle of the glowing research reports, they forget that the point of investing is to make money, not necessarily to make money in XYZ Inc. And even though the market might not be confirming their forecast, they stubbornly hold on because their ego is on the line and they want their fantasy to come true.

Take, for instance, the big pharmaceutical companies like Pfizer (PFE) or Merck (MRK), which for many years investors dogmatically believed were can’t-miss stocks. With more baby boomers needing health care, the fundamental case appeared strong. Blockbuster drugs like Viagra only reinforced the companies’ appeal. Yet because investors had built up such a detailed fantasy of what those stocks were supposed to do, many failed to see just what they were doing — trending downward week after week.

One of the quickest ways investors can distort their rational perspective is to read annual reports, one step I rarely recommend investors undertake. Page through the SEC filings, read the quarterly updates if you like, but make no mistake — the annual report is a sales tool. Flashy ones too easily cloud investors’ judgment of whether to buy, sell or hold.

It’s downright amazing how even the most dismal companies can find ways to show an encouraging-looking chart in the first few pages of their annual report. Keep flipping and you’ll see images of happy multicultural employees and customers, plus lots of pretty pie graphs on heavy glossy paper. Investors fall in love. Their fantasy about the company’s prospects quickly overwhelms the reality of how the stock might be performing. So when the market is melting — the stock is down 20% and falling — they can’t conjure the strength to actually pull the trigger and take the loss.

This is the problem with market fantasy: It prompts you to make emotional decisions from your gut, not rational ones from your head. Even when you have the deepest conviction that XYZ is a terrific company, you must be humble enough to know that sometimes — at least for the short term — the stock just might have to get kicked to the curb.

Rather than spending hours conjuring up a full economic forecast of what will happen, you should try to conjure up an idea of what might happen without writing the whole scenario.

For example, when I was buying gold stocks in 2001, I had a belief that the precious metal would rise, but not a precise notion of by how much. My hypothesis wasn’t contingent on a detailed economic or political scenario, but simply an observation that gold was a strong asset class not yet found by the herd. In short, I had the plot but let the script write itself.

While I certainly applaud those who carefully research their investments, the truth is that once you’ve put money into a stock, all the due diligence in the world isn’t going to affect how it trades. By continually researching and reviewing, investors are prone to becoming too personally attached to particular companies. Dumb decisions are sure to follow.

Ultimately, when analyzing the market, the primary influence should always be the market itself. If the fundamentals happen to look good or the annual report is slick… well, that’s just icing on the cake.

While it’s tempting to have a fantasy about how an investment should work, successful investors will always trade based on what’s happening in the market — not in their heads.

– Originally on Mar 14, 2005 by Jonathan Hoenig

While the losses are limited, the potential gains aren’t. Stocks and bonds are worth whatever someone is willing to pay. So when you buy XYZ, there’s no telling how high it might fly.

The other basic method of making money, however, is what I call the insurance format, an approach best exemplified by the options-writing strategies that have become increasingly popular with individual investors. In this case, a person is paid essentially to assume the risk of ownership without actually owning the security in question. The upside is limited, but the loss isn’t.

An option is the right, but not the obligation, to buy or sell a specific security at a specific price — the strike price — anytime before a specific expiration date. When you buy an option, you pay a fee, known as a premium, to the seller of the option. Option sellers are also called writers. (For more on options visit SmartMoney.com’s Options Center).

Although the premium is generally small relative to the risk of owning the stock, it’s the promise of being able to collect them over and over again that cements this strategy’s appeal to option writers. And while the approach might sound intriguing in the abstract, I firmly believe that speculatively writing options to collect a premium is a strategy most individual investors should avoid. For me, it never seems to work out.

Let’s take the naked put, for example, a trade that immediately appeals to most investors because of its seductive promise of a cash payout upfront. When you sell a naked put — naked refers to the fact that the option writer doesn’t have an offsetting position in the underlying shares — say the XYZ September $50 put, you’re obligated at the request of the option holder to buy 100 shares of XYZ at $50 per share anytime before the close of business on the third Friday in September. In exchange for taking this risk, you receive a premium. If XYZ’s stock is trading at $53 a share, then the premium might be $1 a share, or $100 total (a standard equity option contract represents 100 shares of the underlying stock).

The appeal is obvious: Selling a put nets you immediate cash, in this case $100. And with a naked put, as opposed to a covered put, there’s no extra expense involved in establishing offsetting positions, such as shorting the underlying stock. It seems almost like magic. You make a trade and all of a sudden there’s more money sitting in your account, not less.

You, as the option writer, of course hope that the stock stays above $50. If it does the option will expire worthless because the option holder certainly doesn’t want to sell you shares of XYZ at a below-market price. Best of all, you keep the $100 premium free and clear. However — and this is a big however — if XYZ drops to say $45 a share, then you’re forced to purchase the stock at the above-market strike price of $50 a share. You could also buy back the put at a loss, an equally unappealing proposition (more on this below).

Now do you see why I avoid selling naked puts? Despite the allure of the upfront premium, the strategy subjects you to 100% of the risk with only a tiny fraction of the upside potential. No matter how far XYZ drops, you’d still be obligated to buy it at $50 a share. And regardless of how high it went, the most you’d make on the trade was the $100 premium you were originally paid.

Just as insurance companies take in millions of premiums only to pay out a few hundred claims, successful option sellers need volume for any chance to thrive. That’s why it’s such a tough game for individual investors. Because the upside profit on each sale is comparatively small, you need to write quite a few options to cover the occasional, yet inevitable, catastrophe. Indeed, just a single stock blow-up can eradicate months of collecting premiums.
I’ll admit that puts often expire worthless. And it’s that feeling of a “win,” no matter how insignificant the sum might be, that attracts many people to the approach in the first place. Yet it’s that incessant craving of a win that will often prompt the undisciplined option seller into making a bad situation worse.

Consider this: A common follow-up to a losing put sale is to roll one position into another, buying back the loss only to write twice as many options for a later expiration. So exactly at a time when a stock is most weak, the compulsive put seller is systematically expanding his position — essentially doubling down. From my perspective, that’s a death wish.

Ultimately, I tend to think the option seller is eternally damned. If XYZ falls, he can be faced with losses that dwarf the premium collected. But when the stock rises, he’s missed the real move. So while XYZ might stay above $50 and the put expires worthless, it just might go on to climb to $70, $80 or even higher. You made $1 in premium but missed out on the $30 gain that came with actually owning the stock.

In the market, I was baptized with the philosophy that by keeping the losses small, all you need is a couple of big winners to make up the difference. The insurance format best exemplified by selling options essentially turns that philosophy on its head. Instead of playing for the big moves, you’re forced to churn out lots of small wins, while hoping the big disaster never comes. For me, the approach just doesn’t compute.

– Originally on Mar 07, 2005 by Jonathan Hoenig

Why is hope so dangerous? Let’s begin with the reality that hopeful investors have already bought XYZ. They’re not sidelined money waiting to come into the market, but capital that’s already at work. After going ahead and buying the stock, these investors hope for the best. There’s not much more they feel they can do.

Hopeful investors are almost frighteningly knowledgeable about XYZ, having scoured the company’s Web site, SEC filings and press releases for any kernel of good news. At a moment’s notice, they’re ready with ambitious projections about how many routers Cisco Systems (CSCO) is going to sell or how many listeners Howard Stern will bring to Sirius Satellite Radio (SIRI). They don’t just invest in a stock, they become evangelists for it.

These investors populate stock message boards, posting enthusiastic price targets and detailed notes from company conference calls. They’re also preoccupied with soliciting outside opinions about their picks, desperately hoping to find others to validate their market outlook.

Yet even when a security’s price deteriorates, bearish dissent is unequivocally dismissed. To that end, hopeful investors are essentially blind, so completely immersed in the fantasy of how the stock should move that they’re unable to accept the reality of how a trend is actually playing out. Hopeful investors, to be blunt, drank the Kool-Aid, which makes betting on hope a losing trade just about every time.

At the other end of the spectrum of crowd psychology is doubt, which I interpret to be a highly bullish indicator when it becomes the prevailing attitude of the herd.

To begin with, doubtful investors aren’t investors at all. Unlike hopeful investors, who’ve already put money to work, investors who are doubtful about XYZ usually haven’t bought it — and have no plans to do so.

Doubtful investors aren’t bearish, but rather indifferent. These investors don’t take the time to learn about a company’s prospects or an industry’s history. They’re not familiar with a sector’s ticker symbols or associated derivatives. They don’t know about an investment’s long-term performance or recent price action. In essence, they just don’t care.

Doubtful picks don’t pop up on the CNBC ticker, or make it into the pages of glossy financial magazines. Go to the online message boards of highly doubted picks and you’ll inevitably find almost no discussion at all. Doubtful investments aren’t just unloved, they’re totally unknown.

Even in those cases where a stock has exhibited strong price action, the doubtful attitude is quick to dismiss gains as only temporary. And while hopeful investors have dozens of reasons why a stock should rise, the doubtful perspective can only make the case of why it’s bound to fall. This is the classic foundation for a bull run.

Take, for example, technology stocks. Although we think of the late 1990s bull market as a time of great euphoria for tech stocks, for much of the five years leading up to the peak the prevailing attitude toward the Nasdaq was doubt. Think back to 1997 and 1998, and you’ll recall how, from high valuations to low earnings, individual and institutional investors alike came up with myriad reasons not to get into tech. And while the Nasdaq bubble finally burst, it wasn’t before the market rose for years with the most speculative tech names leading the charge.

It was only after March 2000, once tech finally began to pop, that the pendulum swung from doubt to hope. As stocks cracked and cratered, the herd rationalized losses as merely temporary corrections, with an inevitable bounce-back always right around the corner. Names like Qualcomm (QCOM) and Sun Microsystems (SUNW) continued to be much loved and widely owned. And while doubt kept them out of tech stocks on the way up, it was hope that kept them in on the way down.

A more recent example can be found in the case of energy prices, which continue a rarely interrupted bull run that began more than four years back. As oil has persistently treaded higher, just consider how many doubtful excuses the herd trotted out as an explanation for why prices were on the move. First it was Enron, then the California energy crisis, then the war in Iraq, then election uncertainty and recently the weak U.S. dollar. From $25 a barrel right up to $50-plus, the prevailing attitude has been doubt, with record gas prices perceived as just a temporary phenomenon. Only with ExxonMobil’s (XOM) recent christening as the market’s largest stock has this perspective begun to shift.

My most doubtfully bullish interest right now continues to be utilities, which I first profiled almost six months back. Despite strong performance, the dominant attitude toward the sector continues to be doubt. Naysayers warn that dividends are too small, valuations are too rich and higher short-term interest rates are bound to stop the group’s advance. Meanwhile, stocks like Green Mountain Power (GMP), Wisconsin Energy (WEC) and Brazil’s Companhia de Saneamento Basico de Sao Paulo (SBS) continue to chug higher. That upward price action is all that matters to me.

Nobody knows the future. But in order to make some money, you’ve got to make some moves. When I look at most utilities, including electric, gas and water, I see bullish price action and an increasingly doubtful crowd. Now that’s my kind of trade.

– Originally on Feb 28, 2005 by Jonathan Hoenig

Traders can appreciate it, however, because in the markets there’s no such thing as a regular paycheck. Just as most retailers’ profits are seasonal, a trader’s income is highly erratic. The most common profile consists of long stretches of small losses punctuated by a few impressive scores. And because it’s usually feast or famine, the ability to structure a portfolio toward more-consistent returns is a helpful technique that traders of all levels should employ.

Many traders aim to build consistency into their portfolios in exactly the wrong way: by overtrading. Strategies such as rolling stocks or short-term scalping only contribute to the fallacy that the market can function as a sort of endless ATM, where all you have to do each day is show up to make a withdrawal. And while there are dozens of services that promise you a handful of sure stock picks each day, it’s a loser’s game that serious investors should avoid playing.

While you’d think strategies that constantly turn over positions would be perfect for generating consistent gains, in practice just the opposite occurs. By incessantly taking small profits, a trader never builds up the portfolio of winning positions which, as we’ve often mentioned, is where the real gravy is made. The fantasy of making money by grabbing a little profit every day never works; it only takes one midsize loss to immediately wipe out months of tiny little gains.

To that end, one of the best ways to focus a portfolio toward consistent gains is to tone down the turnover and focus on bigger, longer-term trends. Instead of buying XYZ looking for a 50-cent pop, seek out those opportunities you think could rise by 50% or more — then hold them as long as possible. And while I know nothing feels quite as good as booking a win, the aim is to collect strong positions, not trade them away. If managed correctly, open profitable trades provide far greater upside potential than the practice of constantly liquidating them for another batch of new names.

Just as you should plan on making money on the longer-term trends, so should you expect to take your time in putting money into the market as well. In fact, one of the best ways to aim for consistent gain is to ensure your investments are not only diversified by sector and asset class, but by the time at which you established them. Too often I see overeager investors ready to trade a third, a half or even an entire portfolio in one immediate crack. And while their holdings might be diversified, the fact that they’ve taken the positions all at one particular moment puts them at a distinct disadvantage.

The markets constantly change and provide feedback, letting us know each day how various trends might be developing or falling flat. By moving big chunks of our assets into the market at one crack, we’re trading on only one snapshot of information, neglecting the fact that the outlook might be different just a few days or weeks later. In assembling a portfolio over time, the idea is that there’s always a win blooming. Assets aren’t simply riding the major market cycle, but are tuned to at least a handful of the smaller sequences that’s always operating underneath the surface.

In putting money to work over time, you can capitalize on a period of market information, not just one brief snapshot. I’d budget at least three months to allocate a portfolio of 100% cash, taking my time to monitor, tweak and update the investment strategy in conjunction with the feedback the market was providing.

Finally, one of the best ways to inject steady income into a portfolio is to insist on maintaining a core position of low-risk, interest-bearing instruments. Even with today’s historically low interest rates, I’ve come to enjoy the modest but constant trickle of cash thrown from certificates of deposit (CDs), short-term bonds, closed-end funds and other cash-management devices that help firm up the yield on savings. Such investments boost profit consistency not only by the regular income savings provided, but by helping you maintain the “trader’s portfolio” I first wrote about a few years back.

Most investors are uncomfortable sitting on savings, preferring instead an “all-or-none” mentality of investing every dime — or stuffing it all under the mattress. A trader’s style of allocating assets, however, favors taking smaller, more concentrated bets while keeping a large portion of a portfolio’s assets in defensive, low-risk and highly marketable cash equivalents. I imagine it as an ice cream sundae: a foundation of solid, interest-oriented savings forming the base with a few smart trades and well-played stock picks as the nuts and cherry on top.

Such discipline promotes a strong profit profile by keeping speculative positions consistently sized and focused on your top ideas. Because excess cash is working, and not simply sitting in a money market, traders aren’t tempted to waste capital on lower quality trades. Income generated from the savings can be steered into promising ideas or banked, further strengthening the potential for steady returns.

– Originally on Feb 14, 2005 by Jonathan Hoenig

Other leaders, especially those on the political left, suggest America is founded on the premise of altruistic self-sacrifice. For these folks, no tax or government control is too onerous to provide every citizen with their supposed birthright of housing, health care, education or whichever campaign promise scores high with the focus groups that week.

Lost among the religious right or liberal left is a basic understanding of what core American principles are. Considering that we’re overseeing the process of a new democracy being launched in Iraq, it might serve us to remember what’s at the heart of our own.

The “Textbook of Americanism” was written by Ayn Rand, a Russian immigrant born 100 years ago, who in 1946 penned an unfinished treatise covering the ideological basis for the American political model. In just a few succinct pages, Rand deftly outlined the essential tenets that distinguish America from any other country in the world at any other period in history.

She begins by identifying individualism as the basic principle on which America was founded. Individualism doesn’t mean you’re a loner, or that you don’t play nice with others or work well in groups. Politically, it means that a man (or woman) exists for his own sake, not to serve the group or greater good. A man is an end unto himself, not a means to an end for the public’s disposal. His rights are unalienable, and can’t be cut down or voted away by the majority mob.

The opposite of individualism is collectivism, which, still practiced to varying degrees around the world, holds that people exist for the sake and benefit of the group or public good. Under collectivism, a person has no inalienable rights. What rights he has are defined and limited by whichever gang happens to be in power at the time. In a collectivist society, anything goes.

As a government of laws, not of men, America was designed specifically so that this could never occur. Americanism holds that man’s right to life isn’t contingent on the public’s vote or an opinion poll. In America, an individual’s right to his life, liberty and pursuit of happiness are to be protected, regardless of how the political winds happen to blow.

Over many decades, however, America’s foundation in individualism has been corroded. One of the most obvious examples is the Social Security Trust Fund, whose comprehensive privatization President Bush should be encouraged to propose.

On its face, the collectivism inherent in Social Security is un-American. There’s nothing about the system that is admirable, noble or grand. The system isn’t just immoral — it’s a con. If a private corporation were run like Social Security, its officers would be hunted down by Eliot Spitzer and hung up to dry as the biggest fraudsters on Earth.

Social Security is a Ponzi scheme. Individuals are taxed a significant portion of their income, supposedly to pay into a trust fund to secure their retirement. But there are no accounts sitting in banks with names on them. Money confiscated from your income for Social Security is not saved or invested, but directly transferred to today’s retirees. The only security in Social Security is the hope that future taxpayers’ income will be transferred to us, just as ours has been transferred to others.

Many proponents herald the “guarantee” and “safety” of government-run entitlements. Yet the truth is that every aspect of Social Security is up for grabs, not guaranteed and unsafe. Everything — the age at which you are eligible for benefits, the level of those benefits — is subject to Washington’s political whim. I’d sooner take my chances with a managed mutual fund or even the S&P 500, thank you very much.

The most insulting suggestion I’ve heard is that, although folks had the smarts to earn money, they’re not smart enough to take care of it. When I hear pundits warn about the potential for “Enron-style” disasters if people could invest their own retirement savings — well, I don’t know whether to laugh or to cry.

In a society based on individualism, it’s immoral to be born with a generational debt on our shoulders. So even beyond the fact that Social Security is a fraudulent Ponzi scheme, the real reason it should be eliminated is that it’s in direct conflict with the individualist principles on which this country was founded.

– Originally on Feb 07, 2005 by Jonathan Hoenig

As regular readers know, it’s my belief that the best way to dump stocks is via the use of stop-loss orders, a basic investment technique I’ve been espousing long before Martha Stewart made it famous. To review, a stop-loss order is placed below a stock’s current market price. Should the specified price (or anything below) get traded, the order is immediately executed at the market’s best available bid.

Regardless of whether you take a fundamental or technical approach, stop-loss orders should be an integral part of every trading discipline. They succeed simply by design: By placing one, you’re quietly acknowledging that, yes, even great stock picks can end up as lousy trades.

Stop-loss trades are the bedrock of disciplined trading. Yet the most common problem with stop-loss orders is that they never get executed. Instead of actually placing orders, most folks use “mental stops,” expecting that once a certain price is hit they’ll be available (and able) to make the trade. Few ever are, making mental stops about as useful to a portfolio as mental sit-ups are to abs.

So even with XYZ down 25% from the purchase price, hitting low after low far below where a stop should’ve been placed, many traders will hang on, naively certain that a bottom and rally aren’t far off. Is it denial? Is it delusion? Either way it’s expensive to your bottom line.

All brokerages offer orders on a “good-until-canceled” (GTC) basis, meaning that your stop can be placed weeks, even months in advance. If the market ever trades the stop price, your order is immediately filled. So one need not spend each day huddled over the Ameritrade account. Place your orders and let the market, as I often say, take you out.

Once you’ve committed to trading with stops, the next challenge comes in knowing just where to place them. Some people opt for a technical signal, like placing stop orders at a security’s 100-day moving average. Some use a mathematical approach, selling stocks if they decline 15% from the purchase price or a recent intraday high. Regardless of the approach, the most frequent grievance I hear is from people who complain that their stops always get hit, only to have the market reverse and continue higher.

The real purpose of a stop order isn’t to save a few dollars, but to ensure that you move on from a trade when a market’s trend has legitimately changed. And yes, when you place a stop order a mere 3% below the current market price, it will get hit. So because most stocks, just like a rodeo bull, will try and toss you off before moving higher, it’s much preferable to trade a smaller position with a wider stop rather than a larger position with a tighter stop.

By now it should be gospel: Size kills. And with 15% of your portfolio invested in Taser (TASR) or PetroKazakhstan (PKZ), a tight stop is all that protects against the possibility of catastrophic loss. At the same time, by placing stop orders a mere 3% to 5% below the stock’s current price, you’re just asking — no, begging — for the market to churn you to pieces. Investors end up repeatedly getting stopped out and getting back in, inevitably increasing the position size with each new buy. If you’re looking for an easy way to lose money, this is it.

For the highest probability of success, one should aim to take big chunks, not bite-sized pieces, out of any market move. To that end, if you’re bullish on XYZ, I believe it’s much preferable to trade a smaller position and use a wider stop in order to avoid constantly getting flushed out of your hand. For example, if you were going to use a -10% stop with a 5% position size, I think it’s even better to use a -20% stop with a 2.5% position size.

Nobody knows the future. And by trading a smaller position with a wider stop, you’re actually giving the market a chance to either validate or negate your outlook. Stops placed on uncontrollably large positions end up hanging traders up on the everyday volatility, not protecting them against the possibility of a serious shift in trend.

As we wrote a few years back, trading decisions are rarely black and white — more like shades of gray. And for larger positions, I advocate using multiple stops, a handy approach that works especially well with large, winning trades that might need to be pruned, but not killed altogether.

Say I’m long a big slug of XYZ. With the stock at $50 a share, my first stop-loss order might be near $45, representing a -10% drop in the current market price. At that point, I’d sell a quarter or a third, anywhere up to half of my position. Then I’d wait and watch, setting yet another stop order to protect me should the market decide to continue lower once again.

To me, it’s the most rational approach. As the market weakens, I’ve reduced my risk. But by keeping a portion of the trade in my account, I give the stock a chance to rally back with my holdings still largely intact. If XYZ marches back up to $50, I’ve still got skin in the game and, depending on my outlook, can quickly re-establish a full position. It hurts to sell losers, but it took me many thousands of dollars to realize that success in the market comes not in fighting the trend, but following it.

A final thought on stops: Although there’s no concrete data available, trader superstition suggests that you never place stops at “obvious” prices such as $10.00, $25.50 or other round, commonplace numbers that are likely to appeal to the herd. The rationale? The public is lazy, so when Ma or Pa Kettle establishes a stop, you can bet it’s at $30.00, not $29.87. Because markets tend to cluster and churn where the herd’s stops rest, I try to pick slightly more unusual prices to avoid getting tangled up in the public’s clumsy tracks.

– Originally on Jan 24, 2005 by Jonathan Hoenig

The first harvest occurs quietly, before the news breaks and before the fundamentals become clear, sending the herd crashing through the door. A speculator must be able to look ahead and become bullish on a theme that appears to be working without a clear understanding of why it’s working. Some investors wait for certainty; I simply look for strength. The news and confirmation most people wait for almost always come after the fact.

Like most professional traders, my portfolio has its share of losers. But on those rare instances when an idea actually starts to make money, aiming for the first harvest means you’re one of the few already in line with a growing, winning trade. It’s a position of true strength: You’re in the black in a winning hand while everybody else is just beginning to learn the ticker symbols.

An excellent recent example is gold stocks, which experienced their first harvest back in 2001 and 2002, long before the falling U.S. dollar was on most investors’ radar screen. Although gold is now perceived as a perfectly legitimate part of a diversified portfolio, it’s worth noting that it was before the volume erupted, before the inflation threat loomed, before the metal jumped from $300 to $400 an ounce that many of these stocks truly moved, some gaining more than 100%. That’s the kind of first harvest an investor wants to exploit.

Last week, I highlighted a few of my investing ideas for 2005. While one never knows with certainty where a profit will be found, I try to avoid situations where the odds aren’t on my side, where the first harvest has already been taken. Right now, I believe Sirius Satellite Radio (SIRI) presents just such an example.

It seems as if everyone I meet has been in and out of Sirius over the past few months. Whether it’s because of its low share price in dollar terms or its high profile or both, this stock continues to capture the attention of everybody from institutional investors to the fast-moving message board set. And although I’m excited about the company’s innovations, I just can’t get too jazzed about putting money to work in its stock. For me, the shine is off, the appeal has waned, and I’ve moved on to hopefully greener pastures.

What keeps me away is my nagging suspicion that, despite the company’s promise, the first harvest of gains has already been carted off. In its decade as a publicly traded company, Sirius has traded in a range of roughly 50 cents to almost $70. With the stock at $6.50 recently, both the bulls and the bears have a case. So while there’s no doubt that this volatile stock could be significantly higher or lower, the probability of another 1,000% gain such as the one the stock has seen since 2003 seems rather slim, I think.

From a fundamental perspective, another indication that the first harvest is gone is that the investment “story,” at least for the time being, appears to have peaked. As has been widely publicized, Howard Stern, unquestionably the biggest name in radio, will soon be moving his wildly successful show to Sirius. And because I believe that the stock market anticipates the news rather than reflects it, I can’t help but think that the prospect of big Stern ratings has already been priced into the stock. The company might end up making gobs of cash, but, lest we forget, the share price of many old-school Internet stocks was never higher than before they earned a dime of revenue, let alone profit.

Finally, given the unavoidable buzz over Sirius, it’s hard to make a case that the herd hasn’t already arrived in full-force. This stock is on everybody’s lips and in just as many portfolios. Just take a look at the activity on its message board. For most stocks, a dozen or two new posts each day isn’t uncommon. For Sirius, investors are opining at a rate of one or two new posts a minute, for hours on end.

To make money off the first harvest, one must be able to think and act independently. It’s often tougher than it seems. When people are faced with uncertainty, it’s often more comfortable to be part of a larger group acting in a similar fashion. It’s no coincidence that, according to data from the Investment Company Institute, many people finally bought into the tech bubble in the second quarter of 2000, just as the market was peaking and the promise of information technology finally became crystal clear.

To find the first harvest, the trick is to avoid today’s headlines and imagine what next year’s might be. As a trader, I’m in the business of speculation. When observing the market, I try to extrapolate today’s price action into what might be making news at a minimum of three months in the future.

It also means having the patience to let a move run its course. So when I’m looking at reinsurance stocks, like Aspen Insurance (AHL), ACE (ACE) or Max Re (MXRE) for example, it’s because I think many have the potential to run up 50% from their current prices — not merely pop a few points higher.

You can bet on anything in this game. But for my money, I think the best course of action is to focus on reaping an investment thesis’ first harvest of gains. By the time the news breaks and the crowd starts moving in, the odds for profit rapidly begin to contract. To that end, investors should try to identify a trend, participate in the move and move on. While markets will often consolidate and continue higher, it’s that initial move that provides the highest probability of success.

– Originally on Jan 10, 2005 by Jonathan Hoenig

I grew up a bit the day that I began to think in terms of trading positions rather than stocks. It’s an important distinction, even more important if cash is in short supply. That’s when the tough choices are made. It’s crucial to maintain even the slightest advantage that puts the odds in your favor.

The best position to be in, without a doubt, is to have an open winning trade. That’s the strongest hand. As I mentioned just last week, profits come from winning trades. These are the lifelines of a portfolio, so winners must be the absolute last option to consider when looking to raise cash. I know it’s fun to take a profit, but it’s almost always better to maintain a winning position rather than liquidate it for the sake of buying something new.

Howard Stern got you psyched for Sirius Satellite Radio (SIRI)? Are you pining to get into Plum Creek (PCL)? It shouldn’t matter. Regardless of how promising a new trade might be, I’ve never had success in arbitrarily dumping one stock in order to jump on another. Right off the bat, it stops profits instead of letting them run. Even worse, it breeds the emotional, gut-driven approach that churns many traders to shreds. The only person who gets rich in this scenario is the stock broker.

A much smarter way to raise cash is to analyze overall use of capital. I can’t tell you how much gunpowder is wasted in tiny, useless positions that many traders carry around like old luggage: a hundred shares of Lucent Technologies (LU) in a $100,000 portfolio, or small stakes in mutual funds from three 401(k)s ago. Why do I call these positions useless? Think about it. A stock or fund that makes up one-tenth of 1% of a portfolio could double without having any discernible effect on the bottom line. So when you’re looking to raise cash for a new pick, weeding out some tiny old ones is a great place to start. It becomes a matter of swapping weak positions for a considerably stronger one. If you don’t like an investment enough to have at least a 1% portfolio stake, then I question whether it’s even worth owning at all.

After culling useless positions, it’s time to turn to losing ones. Losing positions are a fact of life. For the experienced trader, they are simply part of the game. And because taking losses is the best way to escape losers, capital for new ideas can be raised by pulling the plug on them. While there are plenty of well-educated investors who believe a loss isn’t real simply because they haven’t yet seen fit to take it, they’re wrong. Only fear of failure encourages investors to hold losers, waiting desperately for them to get back to even. Don’t make the same mistake. Sitting on a losing investment is an inherently weak place to be. Not only is the market not validating expectations, but by holding on the loss can’t be applied against other taxable gains already booked.

When I need to raise cash, I’ll usually try and sell a uniform portion of each losing trade. So if I’ve got four open positions, each down 15%, I’ll sell one-third of each and use the proceeds to fund a new idea. I’ve reduced my exposure to losing trades without eliminating their potential altogether. Also, I’ve taken a legitimate position in what I hope is a promising new idea. Overall, it’s a position of much greater strength than simply rubbing a rabbit’s foot and waiting for a rebound in XYZ.

Beyond useless stocks and losers, a third strategy is margin buying. Once I’m fully committed but still want to jump on a trade, I consider a shrewd use of margin to be an appropriate alternative to marshalling assets. I last wrote about using margin over the summer, suggesting that margin use should be opportunistic, not obligatory. And if there are no useless positions to dump or losing trades to sell, I’d use margin to establish a new trade that represents a smart and timely risk.

Stock trading is a business, and like most businesses, it oftentimes requires working capital to make it run. That’s where margin borrowing comes in. When skillfully deployed, it can strengthen your hand by allowing you to take additional positions without disturbing profitable, existing ones. Think of it as a short-term bridge loan as you shuffle between trades, not an adrenaline fix from which you’ll never come down.

Of course, using margin isn’t free. You’ll pay interest to a broker. But a winning trade — a real winner — will more than compensate for that expense. Profitable trades don’t jump a mere 5%, but somewhere deep in the double-digits.

I can’t stress enough that trading comes down to putting yourself in the strongest position. If there’s an investment you believe is a smart buy, yet all your assets are tied up in profitable trades, I believe it’s preferable to use margin rather than liquidate winners. Assuming you use stop-loss orders on all trades, you’ll inevitably end up generating free cash once one of the investments weakens. That will reduce margin expense while keeping the strongest trades intact.

No matter if you’re investing hundreds of millions or just a few thousand dollars, trading comes down to making choices. The thoughtful investor understands it’s not so much individual stocks that are being chosen between, but positions in the marketplace. The trick is to always maintain the slight edge that a strong, advantageous position provides. So dump the useless, sell the losers and even consider buying on margin to generate the free cash necessary to establish what you consider the best positions for your portfolio.

– Originally on Dec 20, 2004 by Jonathan Hoenig

You can’t blame him, of course, because children haven’t yet learned to look beyond the scope of immediate gratification and consider the future. Grown-ups, however, do comprehend that life exists beyond the here and now. While the future can’t be predicted, most mature adults understand the need to delay gratification at times. They accept that with a bit of foresight, an even higher level of happiness can be found than by simply giving into immediate whims.

This ability to delay instant gratification and stick with a longer-term focus is especially important when it comes to the markets. As human beings, we operate on a relatively short time frame. But the market, whether it’s bullish, bearish or trending nowhere at all, has all the time in the world. An astute investor needs the patience to think ahead, learning to operate on the market’s schedule instead of attempting to cram it into his own.

The hardest thing about having money is knowing what to do with it. And while most states mandate a cooling-off period when purchasing a gun, opening a brokerage or mutual-fund account carries no similar restriction. It’s exceedingly easy to put money to work nowadays, and when emotions are charged, this need for immediate action often leads to poor investment decisions.

I often hear about investors stumbling across a company or product they particularly like. Without an awareness of the stock, the condition of its sector, or even how a purchase fits into overall portfolio allocation, they pull the trigger on a trade, because, well, they like the company and have cash to burn. The strategy usually comes down to putting in a market order the night before and getting it filled at the first (and often worst) price of the day. Good trading technique and discipline are trumped by the simple hankering to get in on the action.

Don’t get me wrong. I admire the medical geniuses at Pfizer (PFE) and adore my Tivo (TIVO), but I just don’t see a need to jump into those stocks given their recent weakness. And even though you might love the management or swear by the product, as regular readers know, weak stocks are weak for a reason. Leave them be. Just like a child learns to save his allowance for a future purchase, the trader must learn to focus only on top ideas and avoid deploying capital on lesser names.

The lesson of delayed gratification applies to taking money out of the market as well. It took me many years and thousands of dollars to realize that the old adage, “take your losses and let your winners run,” is the cornerstone to a successful investing approach.

There’s no better feeling than taking a profit. And on those rare occasions when I’ve got a winning trade on my hands, it’s terribly tempting to simply take the money and run. To delay that satisfaction, that joy, can often be near impossible. Yet just as a child learns that sweets can be bought but not immediately consumed, the disciplined trader is conditioned to hold on to winners — not trade them away. He understands that great gains are born by stifling the impulsive whim to simply make the cash register ring.

It might seem perverse, but the truth is that you don’t want profits; rather, you want winning stocks. So when you’re long XYZ from $15 and the stock’s at $20, I promise you’d much rather have the position than the $5 profit on the trade. Winning stocks are the horses that pull the entire wagon. Get rid of them, and you’ll quickly find yourself stuck in the mud.

To be better equipped to hold on to winners, I run through a mental checklist: Is the position size appropriate? Do I have a stop-loss order in place? Am I able to tolerate the possibility of loss? Provided I can answer yes to all of those questions, I know I’ve done everything I can to maximize my opportunity to make money. From that point on, I sit on my hands and let the market take over. It’s not easy, but in the words of Tom Petty, the waiting is the hardest part.

Now consider the lesson of delayed gratification in another light. When cash is burning a hole in someone’s pocket, it inevitably gets put to work in a less-than-thoughtful manner. As the holiday shopping season begins to peak, it’s important to remember that most people’s money woes stem from how they handle their spending, not their investments.

Just as a youngster will squander his entire allowance, far too many adults somehow manage to spend every dollar they make — and then some. With the widespread availability of credit, the holidays become a convenient excuse to toss fiscal discipline aside. It couldn’t be more unsexy to say it, but forget selling option premiums or trading ETFs. For most people, simply spending less would be the best way to boost the bottom line.

Learning to say, “I can’t afford this,” is one of the simplest yet most effective ways of getting your financial house in order. And although the credit-card companies will gladly loan you money at double-digit interest rates to purchase that new iPod from Apple Computer (AAPL) or sweater from Gap (GPS), financing such a completely unproductive asset is akin to fiscally slitting your throat. Getting a mortgage to buy a house or buying strong stocks on margin are both perfectly appropriate uses of debt. But taking out a loan to pay for a new outfit or plasma TV is sheer lunacy.

The point isn’t to uniformly deny oneself the pleasures of buying nice things, but to become more cognizant of where the money goes and how it can be best utilized. And if you find yourself knee deep in debt this holiday season, buy yourself some peace of mind for the future by reducing spending today and instead, whittling away at outstanding balances. It’s a decidedly old-school approach of which even St. Nick would approve.

– Originally on Dec 13, 2004 by Jonathan Hoenig

So the fact that the decline in the U.S. dollar, which more than a year ago we called “the biggest trend in the capital markets — hands down,” continues unabated should give everyone reason for pause. It’s a sobering thought to realize that the dollars we work so hard to earn and save are simply pieces of paper that, given the markets these days, are worth less and less with each passing hour.

Yet old habits die hard. Because the dollar has long been the world’s benchmark currency, we’ve come to take it for granted that it’s a good store of value. And the absence of widespread inflation in more than a generation makes younger investors especially unaware of how debilitating it can become. Even now, as the story starts to get picked up in mainstream media, many still fail to understand that it’s not so much that the prices of gold and other commodities are rising; rather, it’s the fact that the value of the currency in which we use to purchase said commodities is falling.

Yet although the world is losing confidence in our currency, the trend is largely seen as a phenomenon for the business pages. Most Americans, if they’re even aware that the dollar has weakened at all, don’t care much.

I’m not an alarmist, just a student of history. And because entire civilizations have been toppled as the values of their currencies evaporated, I opt not to avoid the issue but to understand and anticipate how it might be played profitably. Ideally, it’s best to plan for the worst and be pleasantly surprised when it doesn’t arrive.

Money, from the coins in our pockets to the dollars in our bank accounts, is primarily a tool of saving. We exchange labor for a paycheck and opt to hold dollars, more so than animal pelts or spices, because dollars are easier to exchange and because we believe they’ll hold their value over time.

Inflation destroys that process. And what’s the biggest perpetrator of inflation? It’s the government, which, through a variety of methods, is able to spend money it doesn’t have and write checks based on nothing more than future production. Writer and philosopher Ayn Rand describes it as a process in which “the government borrows money today, which is to be repaid with money it will borrow from you tomorrow, which is to be repaid with money it will borrow from you the day after tomorrow…and so on.” This prompts the currency to decline in value, along with the purchasing power of people’s hard-earned savings.

It doesn’t take an economist to understand how it works. As government prints and/or borrows more money, the confidence in the value of the currency declines. This causes prices to rise — and in the case of extreme hyperinflation, skyrocket on a daily basis. Once the purchasing power of a currency begins to drop rapidly, rational people begin buying anything simply to avoid holding cash. Money ceases to be a store of value, and there’s a mad rush to own hard assets at any cost. You can’t eat a piece of paper, nor run your car on it. Financial survival comes down to getting rid of paper currency as fast as possible.

In the U.S., hyperinflation was seen during the Revolutionary and Civil Wars. It was seen in Greece in the 1940s and Latin America in the 1980s. Bolivia underwent a period of hyperinflation in 1985, when prices increased 12,000% in the space of less than a year. Even more recently, rampant hyperinflation was seen in both Brazil and Ukraine in the 1990s.

The most famous, and foreboding, tale of hyperinflation comes not from a fledgling emerging market nor a totalitarian dictatorship, but from early 20th-century Germany, which at that time was an intelligent and highly advanced democracy — one of the most prosperous in Europe. With the outbreak of World War I, the country stopped backing its paper currency with gold. Germany financed the war by first borrowing money, then simply printing more of it. It was a fatal mistake. From 1914 to 1918, the total quantity of paper money created soared almost 1,300% percent — to 33.11 billion marks from 2.37 billion. Inflation also exploded, with wholesale prices increasing over 245% in just four years.

Yet even as the war ended, the printing presses rolled on. From 1919 to 1922, the supply of paper money increased by 2,500%. Prices began to increase on a weekly, daily and, eventually, hourly basis. As money manager George J.W. Goodman (writing under the name Adam Smith) recounts in his book “Paper Money,” “prices that had doubled from 1914 to 1919 doubled again during just five months in 1922. Milk went from seven marks per liter to 16; beer from 5.6 to 18.”

The value of the currency plummeted. Before the war, the German mark, along with other European currencies like the French franc or Italian lira, was relatively stable, being exchanged for between four and five marks to the dollar. By 1918, the mark had fallen to 8.28 against to the dollar. A year later, it cost 191 marks to buy the same dollar. In 1922 the mark fell to 7,589 against the dollar. And by November 1923, the currency collapsed, trading at over four trillion marks to the dollar.

As the currency became worthless, panicked Germans began a rush to exchange paper currency for any tangible good or commodity, from artwork to foodstuffs. In his book, “Before the Deluge: A Portrait of Berlin in the 1920s,” Otto Friedrich writes: “By the middle of 1923, the whole of Germany had become delirious. Whoever had a job got paid every day, usually at noon, and then ran to the nearest store, with a sack full of banknotes, to buy anything that he could get, at any price. In their frenzy, people paid millions and even billions of marks for cuckoo clocks, shoes that didn’t fit, anything that could be traded for anything else.”

Many wealthy Germans were able to avoid financial ruin by holding assets like gold, land or foreign currency, all of which maintained their value as the mark collapsed. The middle class, however, was devastated — a development that historians trace to the rise of the Nazi party.

Let the economists debate what’s causing the U.S. currency to fall today. Why the dollar is weakening isn’t my primary concern. As speculators, we need not be aware what causes a market to move — only that it is moving. And while the U.S. is far from the depths of German-style hyperinflation and financial ruin, we unfortunately continue to trend down that road.

This reality makes gold, an asset I’ve been writing about since it was priced at about $280 an ounce more than three years back, an increasingly attractive alternative to the good ol’ greenback. New financial products such as the StreetTracks Gold Trust (GLD), an exchange-traded fund that I wrote about a few weeks ago, make it easier than ever to add gold to a portfolio. If not now, when?

– Originally on Dec 06, 2004 by Jonathan Hoenig

But while one’s actions should follow age-old guidelines, when it comes to market analysis it’s imperative to think young. Integral to successful investing is an open and imaginative mind. Believe it or not, analyzing investments is one of those rare times when the ignorance of youth can be an asset and not a liability.

A painful experience can easily cloud investors’ judgment over future trades. Think about it. There are plenty of experienced people who won’t even consider gold after getting burned on the sector in the early 1980s. Others swear off biotech after having lost money on the industry in the early 1990s, or technology stocks in the early 2000s. “Once burned, twice shy” is an old, jaded and rather closed-minded way to walk through life.

What matters isn’t how an asset performed 15 years ago, but how it’s performing in the here and now. Younger investors — as well as younger-thinking investors — don’t get hung up on personal histories with particular investments, mostly because they don’t have them. Thinking young means focusing not on how a market normally acts, or how it acted during the Johnson administration, but simply how it’s acting today. (See chart below.)

I recall, for example, how in the mid-1990s, when the price/earnings ratio on the S&P 500 exceeded 20 times trailing earnings, more than a few old-timers preached the case for dumping stocks in light of how “expensive” they’d become. But because past experience shaded their perspectives on the current market, an old approach became more of a hindrance than a help. Yes, P/Es were high, but stocks were strong and stayed strong for years. The ratio marched right on over 25 in 1998, and breached 30 in 1999. During this period the S&P 500 roughly doubled to 1400 from 700.

Older-thinking investors aren’t just jaded by previous experiences, they’re too often critical and dismissive of current opportunities as well. I worked on the floor of the Chicago Mercantile Exchange seven years ago on the day the exchange first launched the electronically traded E-Mini contract on the S&P 500. The old-timers, mostly from the open-outcry trading meat pits, wandered over and voiced their disapproval. “It will never work,” I recall a few of them saying. Their doubts were dead wrong. E-mini futures have gone on to revolutionize the commodities industry, and have helped send shares of the CME up over 350% in just the past two years.

Young investors believe that anything is possible. So while older-thinking investors tend to be almost instinctual naysayers who ask why, those with a younger perspective think big and instead ask why not. It’s that ability to keep an open mind that helps when putting money to work.

Two extreme examples: Back in the early 1990s, Nasdaq stocks were still priced in quarters or eighths and referred to as trading “over the counter.” Among many experienced (read: older) investors, there was a consensus that technology stocks were speculative, unproven and downright dangerous. Who’d think of buying a stock that doesn’t pay a dividend?, many graying players would question. Blue chips were a much smarter place to put money.

Of course, in the following years, the Nasdaq went on to enjoy one of the longest and most pronounced bull runs in stock-market history, with the benchmark QQQ still the most actively traded instrument in the world. The point is that while older-thinking investors were quick to dismiss the new market, those with a younger perspective were happy to accept it — and enjoy five years of unprecedented gains.

On the other end of the investment spectrum, there’s gold. Given the metal’s biblical history as a store of value, one would expect more experienced investors to be open to the notion of gold as an asset class worthy of legitimate consideration. Bizarrely, few still allocate the metal to more than a 5% token position. Despite a move to over $430 an ounce from $250, “gold bugs” are still perceived as paranoid crackpots.

It’s ironic that many of gold’s biggest proponents these days are the same aggressive, youthful traders who championed the Nasdaq just a few years earlier. Because young-thinking investors are able to see every situation with a fresh, unjaded perspective, they’re less likely to harbor preconceived beliefs about an investment’s potential. The old mindset dismisses new information, while a youthful perspective is more ready to accept and act on data that might be incongruent with previous beliefs.

More than any other, the biggest reason that thinking old can hinder investment success comes down to risk. Unlike younger investors, who have the luxury of making up for mistakes over the long haul, older investors are focused on capital preservation. Unfortunately, the need to avoid losses leads them into a fear of taking risks. All too often what we think of as safe investments turn out to be anything but.

During the reign of growth stocks during the 1990s, many investors concerned about the “risky” nature of growth stocks instead opted for “safer” value plays that sported much lower valuations. It was a losing move: Value stocks ended up trailing growth for years on end, prompting one investment journal to write a cover story entitled, “Is Value Investing Dead?”

More recently, S&P 500 index funds, which I distinctly remember as being pitched as being conservative at the height of the boom, have been consistent underperformers, bested by foreign stocks, bonds and smaller-cap stocks.

This is where thinking young — but acting old — becomes the best strategy. As I often suggest, the point of investing isn’t to avoid risk but to manage it. So when looking at investments, the trick is to analyze the market like a youngster, but invest in it with the measured technique of an old saw. The speculator’s job isn’t to play it safe but to take risk in a controlled and disciplined fashion. With appropriate position size, stop-loss orders and asset allocation, the most obscure emerging-market stock becomes no more risky than the good ol’ S&P.

– Originally on Nov 15, 2004 by Jonathan Hoenig

So when putting my money to work, I evaluate not only stocks themselves, but also the stories that go along with them. At issue is determining if the investment thesis, or “story,” has already been played out and picked over by the herd. Like most things in the market, it’s an imperfect science, but the general idea is that by the time the story is out, you already will have harvested your gains and moved on. Watching the media, the message boards and the market can often provide the telltale signs.

If you follow the market, it also makes sense to follow the media, since that’s where stories live and are primarily disseminated. While I try to avoid monitoring the media for investment ideas, I do keep abreast of the coverage of the stocks in my portfolio. A mention on Cavuto or a write-up in Forbes isn’t enough to prompt me to sell, but it is one sign that word is getting around. My job is to find great stocks before they make it on the cover of Barron’s.

The best example is that of the late 1990s Nasdaq bubble. By the time tech stocks peaked in March 2000, the story of their meteoric rise was everywhere. There had been dozens of magazine covers — and even new publications launched solely to cover skyrocketing tech stocks. Bookstores were full of titles about technology investing and how to cash in on the Internet revolution. TV shows like “The $treet” and movies like Boiler Room (both released in 2000) glamorized the fast-money world behind a skyrocketing stock market.

When analyzing the media coverage of one of your holdings, the primary question to consider is whether or not the story is out. So look around: has the bullish case for XYZ been chronicled in the pages of a glossy magazine? Is the stock regularly touted on cable business programs as a safe bet? Does the investment address a news story that has become common knowledge among even the non-professional trading community? Again, there are no hard-and-fast rules, but I consider increased media coverage, especially positive coverage, as one sign of a maturing market. And while it’s not an immediate sell signal, robust media coverage does put me on notice that an investment’s glory days are probably gone.

If the story is written in the media, it’s discussed and dissected on the message boards, a relatively new phenomenon that has become a must-monitor for those getting a bead on their holding’s public exposure. In the space of a few short years, message boards have become the investment community’s virtual town square. Every now and then, it pays to stop by and listen in.

Yahoo Finance’s message boards are probably the most populated and well known, but there are others worth keeping tabs on. Silicon Investor, Motley Fool and Morningstar all host boards, and even Raging Bull, the mid-1990s birthplace of message board banter, is still alive and clicking.

Active message boards are populated by a wide variety of participants. There are the new or beginning investors inquiring about a company’s earnings, dividends or future prospects. There are the regular posters, oftentimes sophisticated, well-versed voices who listen in to a company’s conference call or sift through their Edgar filings with a fine-tooth comb. There are the foul-mouthed blockheads who revel in online squabbling over the most insignificant issues, and spammers posting off-topic pitches for thinly traded pink-sheet names. Even a company’s employees or management will participate (often anonymously) in the discussion.

I don’t post to message boards, but I do monitor their activity. Just like analyzing the media, the idea is to assess whether or not an investment story is out or not. Discussion boards provide an excellent, real-time indicator of how information is being received and perceived by a wide range of investors.

As regular readers know, I strive to avoid the herd. So it might not surprise you to learn that most of my favorite stocks have absolutely moribund message boards. The fact that the Yahoo message board for International Power PLC (IPR) hasn’t had a posting in more than nine months doesn’t bother me at all. In fact, I interpret it as a bullish sign that, despite the upward trajectory in the stock, the story isn’t yet out yet. When evaluating a stock, I’m generally dissuaded by those with hugely active message boards and very frequent posts. I want to get there before the story is written, not when it’s already being systematically picked apart.

Quantity of posts is one sign; quality is another. Bull markets are built on doubt, not hope or overconfidence. The more certain the message board community seems about a company’s prospects, the more likely I am to begin planning my escape. So I evaluate the tone of the posts. Are they irrational or emotionally charged? Do participants make grand predictions about a stock’s limitless potential? Are naysayers ridiculed and shouted down? All are indications that the story, and thus the potential, of a particular investment might have already reached its peak.

Finally, in addition to watching the media and message boards, a trader must also watch the market itself. The manner in which a particular stock trades can often give an indication as to how well-known its story has become.

The ideal price action for a stock is a slow, methodical upward trend. As we often point out, big moves in the market take time. A quiet upward climb doesn’t attract the attention of reporters or hot-money momentum players, which is exactly what you should want. Violent surges or big one-day moves usually mark the end of a trend rather than the beginning of one. I want a stock that silently ticks higher with absolutely no buzz — not one that thrashes around as the subject of endless banter and debate. Once a stock ends up on the list of the day’s biggest percentage gainers, the story is already out. By that time, I’ve hopefully begun scaling out of my position, not just starting to acquire it.

– Originally on Nov 03, 2004 by Jonathan Hoenig

Since you can’t bet on everything in the markets, it’s imperative that an actively managed portfolio be equally focused. That’s because the most economical use of capital comes from homing in on a handful of key investment themes. In the words of Mark Twain, “Put all your eggs in one basket — then watch that basket.”

At any given time, my hedge fund is involved in no more than a half-dozen investment themes. It might be an asset class such as gold, or a particular sector such as utilities or a group like foreign stocks. The point is that the portfolio’s risk is centralized around a few major ideas.

In an obsessive effort to reduce risk, we frequently limit any chance of reward as well. Far too often, diversification becomes the excuse for disorganized and inefficient portfolios — hodge-podge collections of ill-sized securities and broad, overlapping mutual funds set adrift without any apparent plan or strategic approach.

What sinks these investors isn’t their stock picking, but their inefficient use of capital. Big chunks of money are pledged to funds so diversified that only a double-digit move in the Dow or S&P could make owning such large positions worthwhile. And while a particular stock holding might indeed rally, the position size is inevitably so small that the move has no meaningful effect on the portfolio’s bottom line. Capital is invested, but not in an economic or effective manner. Even successful stock picks aren’t fully exploited.

I put money to work around a big idea. I take a focused, thematic approach that, just like a TV sound bite, can be easily summed up in just a few words. Regular readers will recognize the strategy. From Internet stocks to Latin American names, over the years I’ve highlighted numerous specific ways in which a focused approach would’ve garnered substantial gains.

But just because an investing theme can be reduced to a few words doesn’t mean it’s easy to execute. In the markets, nobody knows what’s going to happen. With that in mind, I use two basic strategies to establish positions once I’ve chosen a theme worth pursuing. Depending on the nature of the investment, I’ll employ either a concentrated or a comprehensive technique.

A concentrated approach means taking a larger position in a small number of securities all connected to one major theme. It’s a strategy that tends to work best in more liquid, established markets. The primary goal is simply exposure to the asset class.

Gold, which I last wrote about a few weeks ago, provides an excellent example. If you believe gold is a worthwhile long in today’s market environment, then the idea would be to establish such a position in the most economical way possible. Rather than buy a half-dozen different gold stocks, I’d take slightly larger positions in a smaller number of benchmark securities highly correlated with gold. ASA (ASA), for example, is a closed-end fund with broad exposure to precious metals, and both Newmont Mining (NEM) and Glamis Gold (GLG) are dominant members of most gold indexes. A healthy position in any of these would quickly achieve the goal of getting direct exposure to gold.

Or say you expect non-U.S. companies to outperform their domestic counterparts, leading to the big idea of European stocks. Instead of subjectively determining which equities are worth owning, you could simply get exposure to the asset class through one of the popular exchange-traded funds that tracks European stocks. For example, iShares S&P Europe 350 Index Fund (IEV) holds a broad assortment of European stocks such as HSBC Holdings (HBC) and GlaxoSmithKline (GSK). And while the ETF itself is diversified, establishing a 3% to 6% position size within a portfolio would constitute a concentrated approach that would directly benefit from the relative strength in non-U.S. stocks. StreetTRACKS Euro Stoxx 50 (FEZ), which I highlighted last December, would also effectively achieve the same exposure.

The other general method for playing a big idea comes in what I call a comprehensive approach. It involves taking a larger number of smaller positions around a central theme. It’s most effective when used for very specific industries, or in those sectors that lack an ETF or other index-tracking security.

For example, take utilities stocks, a sector in which regular readers know my fund is currently heavily involved. Given the weakness in the dollar, it appears to me as if foreign utilities offer up the best potential for appreciation. And because foreign utilities is a very specific theme, I’m able to take a comprehensive approach and establish positions in virtually every legitimate name.

In this case, I don’t just dip my toe in the water; rather, I cannonball in with both feet. If I want exposure to foreign utilities, then I’ll take numerous positions in a half-dozen or so of what I believe to be the most promising names. I buy some large stocks caps like Enel (EN) and Eon (EON) along with some smaller names like United Utilities (UU), International Power (IPR) or Companhia Energetica de Minas Gerais (CIG). I’ll buy the foreign natural-gas plays like BG Group (BRG), or the water utilities like Veolia Environnement (VE) or Suez (SZE). Shortly put, I’ll canvas the sector, knowing that, should the overall idea hit, I’m well positioned to have at least one holding that generates a substantial return.

I can’t stress enough that small positions are all but worthless because they rarely boost the overall return of a portfolio. The same goes for large allocations to overly diversified funds. These are two of the most common ways that resources are inefficiently deployed.

To me, a more focused approach, in which a limited number of major themes dominate a portfolio at any given time, makes more sense. Using proper technique, a concentrated (read: large) position in a specific sector or asset class is an effective way to participate in a trend. In more limited markets, I’ll opt for a more comprehensive strategy that involves purchasing a larger number of securities across the entire spectrum of a specific idea. Winners are preserved, losses are minimized, and, ideally, the theme comes into fashion with a few of your holdings leading the charge.

– Originally on Oct 25, 2004 by Jonathan Hoenig

The Right Move
There’s no crystal ball. And while I’m always quick to discount the comparatively minor importance of market prognostication, the stubborn reality is that you can’t make any money if you can’t pick a winner. The best way to find winning investments is to look for them in the right way.

Yet many players are doomed from the start. The most predictable losers are the get-rich-quick crowd, who gravitate toward the OTC Bulletin Board, Pink Sheets and super low-priced stocks. All, even the “blue chip” penny stocks I wrote about a few years back, tend to be appealing yet low-probability trades.

What damns those companies listed on the Bulletin Board or Pink Sheets isn’t their business prospects, but their lack of liquidity. And while it’s appealing to buy thousands of shares of a $1 stock, even exchange-traded issues in the low single digits are often priced as they are for good reason. There are better approaches than simply looking for the lowest priced stocks you can find.

Some investors specialize in one particular market or industry, a lucrative move when that particular segment becomes fashionable with the fast-money crowd. I recall how, in the late 1990s, tech stars like Garrett Van Wagoner or Seligman’s Paul Wick were hounded like rock stars. A mere mention of their favorites on “The Money Club” could send a stock up 20% the next morning.

Instead of focusing on an industry, one should concentrate on his own approach. Because while the market is always unpredictable, our own actions are decidedly under our own control. What matters isn’t having a stock tip, but sticking to a discipline. If you follow the fundamentals, searching for low price/book, or high price/earnings, or improving revenue or upwardly revised EPS, then more power to you. I personally opt for a technically oriented approach, though the same uncertainties apply. Is the 200-day moving average somehow more valuable than the 190? Or the 185? Do stocks with positive stochastics or on-balance-volume (OBV) always end up hugely profitable winners? Of course not.

The Holy Grail is a myth. But a good discipline, regardless if it’s fundamental or technical, won’t only help minimize the pain from losing trades but protect the upside from those occasional winners. Nobody is right 100% of the time. But when he is, it’s good discipline that helps a trader fully capitalize on the move.

The Right Time
Making the right move is just the start. Equally important is when to make it. So much of life, from relationships to ball games, comes down to timing. Investments don’t exist in a vacuum. Investors own them for a specific period of time, during which the hope is they can be sold at a higher price than they were bought. Why is that so difficult?

For one thing, timing in the stock market is often completely counterintuitive. After all, if making money came down to simply buying solid, profitable companies, then we’d all be rich. As I often point out, a stock and a company are two different things. There are plenty of successful, reliably profitable firms with perfectly moribund stocks. And oftentimes the highest flying stocks belong to companies without a dime of revenue to their names.

The market pays those who take a risk, not those who bet on sure things. To that end, the best time to buy a company’s stock is often directly in the face of uncertainty or outright fear. Again, consider the tech boom of the late 1990s. When email was still a novelty and Web addresses seemed like a foreign language, most people dismissed tech stocks as either too risky or too expensive. In fact, the herd waited until early 2000 to finally get into leaders like Cisco (CSCO) or Sun Microsystems (SUNW). By that time, the scope of the Internet’s enormous impact was finally understood and, of course, the major gains for benchmark stocks had already been made.

For my money, the best time to buy a stock is when it’s strong — end of story. Let David Dreman buy falling knives and wait quarter after quarter for the turnaround. Where I’m from, strong stocks tend to stay strong, or at least stronger than the weaker alternatives. Simply put, trends (where they exist) tend to persist. My approach is to wait for them to materialize, and then try and hop onboard.

The Right Way
As I often point out, it’s not the market that hangs us but our own actions. And even when you buy the right stock at the right time, you’re likely to lose money unless you do so in the right way. Trading comes down not to stock picking but technique. There are innumerable ways to doom a ship before it even leaves the harbor.

The most common mistake I see is undercapitalization. Trading can be downright addictive, and unfortunately that attracts many participants simply not flush enough to withstand the market’s inherent volatility. So although you can open a discount brokerage account with as little as $500, I don’t see why you’d want to. Even at a reduced commission of, say, $5 a trade, each transaction would still account for a mammoth 1% of total portfolio value. As I wrote almost three years back, I wouldn’t trade individual equities unless I had at least $5,000 in risk capital. Without adequate resources, it’s just too easy to get churned and chopped into the ground.

Another important component of trading the right way is to pick the instrument most appropriate to your account. For example, let’s say you wanted to capitalize on the hard-asset boom by taking a position in gold. Despite the fact there’s still no U.S.-listed gold ETF, there are still any number of ways in which to play the sector. You could buy gold-mining companies such as Glamis Gold (GLG) or Crystallex International (KRY). You could buy open-ended mutual funds like Tocqueville Gold (TGLDX) or the closed-end types like ASA (ASA) or Central Fund of Canada (CEF). You could buy gold futures, such as the mini-sized contracts I wrote about a few weeks back. You could even buy physical gold bars from reputable dealers such as CNI or Richard Smith’s OnlyGold. The point is to match your market expectations with the most appropriate product, given the size of your account. Even if you’re dying to trade futures, doing so with an $800 portfolio is simply a disaster waiting to happen.

Of course, making an investment the right way also includes the various portfolio techniques with which regular readers of Tradecraft should be more than familiar. For example, rather than subjectively deploying capital based on a gut feeling, experienced traders use consistent position size (1% to 3% of assets) and think in “units,” not dollars. Although there are high hopes for every trade, it goes without saying that stop-loss orders should now be an integral part of every investor’s game plan. Finally, effective diversification, trading across asset class, market cap and even time help mitigate the risk of a highly concentrated position. All are integral to long-term success.

– Originally on Oct 11, 2004 by Jonathan Hoenig

We can always opine about the economy or venture a guess on the next direction for the Dow. But through bull and bear markets alike, I keep coming back to fact that real wealth isn’t built from a good stock tip but from making prudence and frugality part of the everyday routine. Considering the exceptionally uninspiring state of the U.S. stock market, I believe now is an especially smart time to take a few weeks to get the financial house in order.

The stock market is an endlessly fascinating, dynamic and downright addictive animal. Yet most people who obsess over stocks ignore the real problem: poor financial habits. And although it’s super un-sexy when compared with day trading e-Minis or writing covered calls, the truth is it’s the little things — eliminating debt, reducing expenses and saving — on which fortunes are built. I don’t care how fast your quotes are: The market is always a crapshoot. However, developing good financial discipline, and sticking with it, is a guaranteed way to boost your bottom line.

If your goal is to have more money, then you must know that credit-card debt doesn’t just slow the process, but suffocates it altogether. And while card companies get a bad rap as shylocks praying on an unsuspecting public with “predatory” practices, the truth is that credit cards, when paid off, are an amazing deal. Think about it: A company is giving you a 30-day float, a host of loyalty points or incentive miles, a detailed record of every penny you spend and the safety of not having to carry currency all at no charge whatsoever. All they expect is that you pay for what you purchase in a timely matter. Is that too much to ask?

Problems mount, however, when credit-card debt isn’t paid off. Considering the average balance is now over $8,000 for families with one card, for millions of Americans, simply reducing this high-interest consumer debt would make a world of difference to financial health. That’s where it all starts. There’s no sense in putting one penny in stocks when you’re dragging around revolving debt on a Visa or MasterCard. Consolidate your bills on the card with the lowest rate, and then focus on eliminating it altogether. A useful motivational tool is SmartMoney’s Debt Management Worksheet, which quickly calculates just how much interest is racked up by carrying a balance — even on a low-rate card.

Forget rolling stocks or scalping ETFs. The easiest way to have more money is to spend less. And while necessities aren’t expendable, many indulgences are, oftentimes with negligible impact on quality of life. Although I don’t follow a strict budget, every few months I go over my bills and bank receipts to figure out exactly where my cash goes.

The remarkable thing about our material possessions is how many of them are actually worth absolutely nothing at all. I don’t deny myself things I can afford, but I’m increasingly aware that most everything, from a book to clothing to a piece of furniture, is rendered practically worthless the moment it leaves the store. Look around the house. Chances are you’ve spent thousands of dollars on items that right now wouldn’t fetch a fraction of that price.

And yet frugality need not hurt; in fact, it’s actually hip. A decade ago, it was the “simple” lifestyle and fuel-efficient Dodge Neon cars that symbolized living beneath one’s means. Now the trend is exemplified by selling knickknacks on eBay (EBAY) or shopping at Target (TGT).

The answer isn’t to cut out shopping, but to become more conscious about it. So track your spending for a few weeks — chances are you’ll notice plenty of money being wasted on items that, truth be told, really aren’t worth buying in the first place. And when I take a moment to prune my purchases, like canceling the premium channels I never watch or not renewing the magazine subscription that’s rarely read, it’s surprising how much a few bucks here and there will add up.

Of course, once you have money, the hardest thing is figuring out what to do with it. And in our technologically advanced age, you don’t hear the term savings much anymore. People make investments. They have portfolios. Saving feels like something that went out with vaudeville, Jimmy Durante and the Model T Ford.

Yet given the state of most people’s financial affairs, the first stop after accumulating some wealth shouldn’t be a mutual fund or stock brokerage, but a bank. It might seem old-fashioned, but I believe that savings should form the foundation of everyone’s finances, no matter if they’ve just started working or are already retired.

For those just starting out, an ideal goal to work toward is an “emergency fund” — six to nine months of living expenses, in cash, in the bank. Once that’s achieved, shoot for a year. You’ll be surprised how much brighter the world is when you’ve got 12 months of food and mortgage payments sitting in a savings account or CD.

And while the prospect of making meager returns in a bank account doesn’t send the heart racing, the truth is that savers can be savvy as well. For example, it’s amazing to me how many people pass up the chance to make a cool 100% on their investment simply by tying up their savings for a slightly longer period of time.

According to Bankrate.com, the average money-market fund is currently yielding around 1.40%. Yet by buying a one-year CD, it’s possible to double that return with no risk of loss. It seems insignificant, but when habitualized over time, a few percent will add up. Big companies spend countless hours figuring out ways to squeeze out an extra quarter point on their money. So should you.

– Originally on Aug 16, 2004 by Jonathan Hoenig

While fundamental analysis might succeed as an academic exercise, as a legitimate investment tool I believe it falls flat. Besides the fact that evaluating a company’s operations, management, competition, technology and regulatory landscape is nothing less than a full-time job, the implicit premise of fundamental analysis hinges on the assumption that a company’s economic condition will ultimately be reflected in its stock price. Yet as we’ve seen time and time again, a company and a stock are two separate animals altogether.

And because it’s the price, not the balance sheet, that we trade, technical analysis offers a significantly more useful method of evaluating markets. The basic premise of technical analysis is that the markets, like most things in nature, tend to move in trends that persist over time. So while fundamental analysis is rooted in often arbitrary assumptions and expectations, a technical approach correctly prescribes that we observe the market as it is, not as we wish it would be.

The technician understands that what we think about the market matters much less than what we see occurring within it. So while the fundamental analyst tries to predict, the technician aims to observe. And because the best indicator of the market is the market, being less opinionated and more informed leads to better investment decisions across the board.

For example, I find far too many fundamentally minded investors who are dead set on making money their way, and their way only. So instead of letting the market dictate their trading thesis, they’re intent on fitting the market into their presumptions about how things ought to be. During the 1990s tech boom, they clutched to bonds, value stocks and the high-dividend plays that should’ve risen, even as all underperformed growth stocks by a wide margin. Most technicians correctly dismissed those groups as weak, and avoided them even as their fundamental story became more attractive the further they fell.

If nothing else, technicians are disciplined. From what I can tell, the traders who self-destruct and cannonball their portfolios tend to be fundamentalists who can’t accept a market not confirming their deeply held beliefs about the world. Technicians, on the other hand, are inherently more likely to go with the flow, accepting the market as it is and leaning to alter their approach.

I don’t care how fast your fingers are, given the speed at which information is now disseminated, it’s downright impossible to profitably react to a piece of fundamental news as it’s publicly released. Regardless if it’s employment figures or a company’s earnings announcements, fundamental information is immediately absorbed by the market and factored into market price. Although there’s usually volatility surrounding the announcement, there’s rarely any real opportunity to actually make a buck. By the time it’s out, the real move has already been made.

That presents another big advantage of utilizing a technical approach. Although it’s a difficult concept for new traders to grasp, the fact of the matter is that markets generally anticipate news rather than reflect it. So you’ll often see, for example, stocks rise in the weeks ahead of a positive earnings announcement. That’s also why commodities such as gold and oil strengthened for years before inflationary signs began showing up in economic data.

Because technical traders know that the market generally moves before the news breaks, they tend to operate under the premise that less is more, focusing on owning strong securities even before there’s an easily digestible news peg to explain their outperformance. Technicians trust the market, knowing that in most cases the news catches up eventually to what the price action has already predicted.

Because they’re overloaded with data, however, fundamental analysts are often presented with conflicting signals regarding a particular trade. They might be bullish on XYZ’s new product rollout, but the company’s latest earnings announcement failed to meet expectations. Meanwhile, the macroeconomic picture suggests continued strength, yet the company’s management all seem to be selling the stock. The net effect: paralysis by analysis.

Importantly, I believe technical analysis helps to nullify one of the biggest drags on portfolio management: our own emotions. Trading is a mind game, and although we’d like to think of ourselves as rational beings operating in our own economic self-interest, when the money starts flying, it’s all too easy to lose one’s head.

When practiced correctly, technical analysis not only helps formulate what to buy, but how to buy, presenting a disciplined, rules-based framework for allocating resources and controlling risk. As I wrote last year, even a basic 200-day moving average can give a trader much-needed structure. When XYZ crosses above its moving average, it’s a buy. Should it fall below, it’s a sell.

Although it’s an elementary approach, it provides exactly what fundamental analysis doesn’t: a concise plan for getting into and out of a particular market. Fundamental analysis tends to leave traders alone in the woods. “Good” companies are purchased and held up until the fundamental picture deteriorates. Of course, by that time, who knows how far the stock has slipped.

And because it’s the market, not our own opinion, that dictates our actions using technical analysis, investment decisions are inherently more objective, rational and level-headed. For example, when managing a stock holding we were given as a gift, or even a position in a company we particularly like, it’s often far too easy to forget it’s the stock we trade — and not the story. There are plenty of great companies with downright lousy stocks. Technical analysis plays no favorites. When followed correctly, every security is dealt with in the same disciplined fashion.

More than a fast Internet connection or a hot stock tip, what traders truly need is a consistent and disciplined method of analysis that can be used across any number of markets or economic environments. By definition, trading is the business of speculation. No matter how much research or due diligence we do, nobody knows what’s going to happen. There is no holy grail.

In the final analysis, I do believe most traders will find technical analysis to be the most useful method of investment research. Unlike fundamental analysis, it focuses exclusively on what’s important: a security’s price action. And because the market, and not our hunches, dictates the approach, it helps to remove the emotional obstacles that too often lead to undisciplined trading. Finally, technical analysis succeeds because even at the most basic level, it provides a disciplined code of conduct for getting into and out of the market.

It might not get respect, but more often than not it gets results. And that’s all that matters in the end.

– Originally on Aug 02, 2004 by Jonathan Hoenig

Of course, debt is always a double-edged sword, and must be used with the greatest of care. In both investment portfolios and personal finances, debt should be a financial tool, not a way of life.

When it comes to investing, debt is most commonly used in the form of margin loans. It’s a simple process: Investors borrow money from brokers to buy securities. The expectation is that the investment return will more than cover the interest payment on the loan.

And there are plenty of investors, especially those who see investing as entertainment, who always trade the biggest positions possible, leveraging themselves to the hilt in the process. No matter what the state of the market or their portfolio, they’re dead set on swinging the biggest line their broker will allow. It’s a dangerous policy, often with expensive consequences.

For me, margin is like the good silverware or bottle of Cristal — it’s to be brought out only for special occasions. I use leverage sparingly, for good reason and for only a short period of time. Specifically, I’m likely to use margin only to support a strong position and, in most cases, when I’m playing with the house’s money (more on that later).

As we first pointed out a few years back, successful traders tend to capitalize on their moments of strength, not moments of weakness. Just as professional gamblers always split aces and eights, skilled traders aren’t afraid to bet big when the odds are tipped even slightly in their favor.

Let’s say, for example, that I’m holding a profitable position in Northrop Grumman (NOC). Although my current position is appropriately sized, I observe continued group strength in major defense stocks and want to capitalize on the trend. Even if I had no available cash to invest, I’d be inclined to use margin debt to add a new position in Lockheed Martin (LMT). The move would diversify the winning exposure and still keep capital focused on a major, timely trend.

I’ve written about these “sister” positions before. Because stocks tend to move in groups, I think it’s acceptable to use margin in order to turn a solitary trade into a full-fledged, multi-security position. Simply put, it’s a smart risk. Instead of simply betting the farm on Northrop, I’m then able to trade the two exposures, getting stopped out of one position, for example, while simultaneously taking a new trade within the same sector. The point is that margin use should be opportunistic, not obligatory. When trading between positions in a strong market trend, margin is a terrific “bridge loan” to help when shifting risk.

Regrettably, and inevitably, margin isn’t always used under such rational circumstances. And as I’ve pointed out before, the market doesn’t slit our throats — we do it ourselves. Once the discipline goes, the money is quick to follow. Margin just makes the losses quicker and more severe.

Basic prudence suggests that as equity drops, so should debt. Yet most inexperienced traders use margin in the opposite manner, attempting to recoup losses instead of maximizing profits. That’s the troubling thing about margin. It often makes people do things they don’t want to do.

When facing a drawdown, some people panic, immediately taking big, leveraged positions in losing trades, ETFs, small-cap stocks or anything that moves. When coupled with margin, that unhealthy instinct to get back to even can be portfolio suicide. As your account shrinks, the approach puts you in big positions in low-probability trades. For every time such recklessness works out, there are a half-dozen or more times when the market carries you straight to the morgue.

Trading on margin is like a drug, and once you get a taste, it’s hard to wean yourself. My general rule of thumb is to use margin only when I’m trading with the “house’s money” — that is, when I’m in a profitable position in which my equity is growing, not being slowly hacked away. If I’m having a losing month or quarter, my instinct is to turn down a portfolio’s leverage, not dial it up.

In the market, I’m a strict technician. But when it comes to my personal finances, I’m a pure fundamentalist at heart. Because managing finances is like running a small company, working toward a sound balance sheet is integral to long-term profitability. Just as with investment portfolios, debt in the personal-finance realm should be used sparingly, strategically and only for good reasons.

The best thing most people can do with their money is save it. I can’t tell you how many investors I consult with who have respectable portfolios but high debt levels. Truth be told, a $2,000 stock portfolio is insignificant when coupled with a $10,000 credit-card bill or half-million-dollar mortgage.

The market is always uncertain. But paying down debt is the closest thing to money in the bank. Even if your credit-card or mortgage rates are low, retiring debt provides a guaranteed return on investment that the market can never touch. In fact, I don’t believe investors should go near the stock market until their credit-card bills are retired and their mortgage constitutes no more than twice their liquid net worth.

Not only do many people have poor debt-to-equity ratios, but the money they do save has a negative carry, meaning that they’re actually losing ground when interest is taken into account. For example, there’s no use in buying certificates of deposit paying 2% while borrowing money from a credit-card lender at three times that amount or more. You’re much better off simply getting rid of the debt.

To that end, it’s my belief that the only types of purchases worth financing are those that are likely to provide a tangible return, such as a house or an education, but not books from Amazon (AMZN) or outfits from Ambercrombie & Fitch (ANF). Because most consumer goods tend to lose their value immediately after they’re purchased, borrowing money to finance a fancy dinner or Pottery Barn shopping spree is a poor use of capital. Although you can finance such purchases with credit, you shouldn’t.

If you can’t afford to pay for it with cash, you can’t afford it. End of story.

– Originally on Jul 19, 2004 by Jonathan Hoenig

When I’m asked what I think of XYZ, I’ll gladly share my two cents, along with my perspective of how to best approach and, even more plainly, how to trade the particular investment. As I often point out, it’s technique, not simple security selection, that has the biggest impact on success. What lays between the folds of simple “buy, sell or hold” nostrums are the details of where money is actually made.

When asked about XYZ, some people analyze it on a micro level, offering their perspective on management, the company’s products or competitive pressures within the sector. Others peer through the macroeconomic lens, pontificating on how business cycle, interest rate or currency trends might affect the stock price in the future.

Of course, what matters isn’t what people say about the market, but what ends up in their portfolios. So when I’m asked about XYZ, I start with the real issue: whether or not you are considering the stock as a new purchase, or if you already have it as a position in your portfolio. While it might seem rather trivial, the response clearly dictates how the stock is analyzed and ultimately handled within the context of an overall portfolio.

So what do I think of XYZ? To start, let’s assume that you don’t already own the stock, but are considering it.

I don’t buy stocks for fun or entertainment, or because I need cocktail-party conversation to fill the dead space between drinks. I buy them to make money. And if you put a dollar into anything less than a disciplined and focused strategy, you might as well throw away the dollar, or at least blow it at the racetrack or casino. You’ll lose less money there and, well, have more fun.

There are plenty of stocks worth liking — but only a precious few on which I pull the trigger and buy. And because I can’t bet on everything, new purchases should always be the cream of the crop. They should be the “it” stocks — the timely names that I consider my absolute best ideas in the current market environment. I don’t buy sub-par stocks just to diversify. The stocks I buy are those I feel I must own out of my own greedy self interest.

Oftentimes, people will ask about a stock that has recently been in the news for some reason. And as regular readers know, for me, that’s usually a sign to stay away. A stock is in the news for one of two reasons — good news or bad news. In my world, both are usually worth avoiding.

Take a stock that’s making news for positive reasons — say, better-than-expected earnings or an important new ruling from the FDA. Maybe Norman Rockwell or Thornton Wilder in their day could read about a stock in the newspaper, call their broker to place an order, and still make money on the move. But in the 21st century, people just don’t have that kind of time. Today, as soon as market-moving news is released, the market has already moved. By the time investors are able to trade on it, the real gravy has already been made.

Stocks in the news for bad reasons are equally unappealing. While I admit there are any number of ways to make money in the market, where I’m from, you don’t buy XYZ simply because dropped 20% and you’re sure you can scalp it for a point or two on a dead-cat bounce. As seductive as it might seem, it’s a fool’s game that rarely seems to work out.

As I often point out, the best indicator of the market is the market. So if you’re looking at XYZ, you’d better know how it has been trading of late. For new purchases, the only stocks I consider are those showing strength, the telltale signs being positive price action in both the stock itself and the industry group to which it belongs. I also like to gauge where the herd is, only focusing on stocks where I’m certain they’re not yet active.

If a stock is strong, the group is acting similarly and it’s not yet waterlogged by the herd, it just might be right for your portfolio. Whether you’re buying a Nasdaq stock or a bond mutual fund, new purchases must follow all the tenets of disciplined investing, including consistent position size, reasonable leverage, stop-loss protection and proper asset selection.

The point is that new purchases should be the best of the best — the top 1% of your ideas that are acting well in today’s market. I look for the strongest stocks in the strongest groups, those names that aren’t yet in the news, but are quietly in the process of making it. Once I’ve decided to take the plunge, I use disciplined trading technique to ensure that, even if I’m wrong about XYZ, the damage will scar but not sink my portfolio.

Let’s consider the other side of the coin, the possibility that you already own the stock in question. In that case, “What do I think of XYZ” becomes a different matter altogether. Because you already own the stock, the issue now becomes evaluating that particular position. For me, that starts by determining whether it’s being held as a win or a loss in your account.

Losing trades are a regular part of investors’ lives. But for whatever reason, most people just won’t sell their losers. Instead, they ask everybody else’s opinion, hoping to get one positive response that will justify them holding on to XYZ for another few months. Indeed, most people drag their losing trades around like old furniture. Unlike wine or good cheese, bad trades rarely get better with age.

So if you’re sitting on a 20% loss in XYZ, you need to set a plan of getting out should it continue to drop. For me, that doesn’t mean selling stock outright, but setting up one or more (depending on the size of the position) stop loss orders below the current market price that, if breached, will automatically sell me out of the trade. Some people pick stop orders using technical analysis, others use a percentage decline. It frankly doesn’t matter how they’re created. The point of having stops is to have them — and to follow them should they get hit.

The market doesn’t hang people, but it does give them the rope by which to do it themselves. The quickest way to do that, in my experience, is to add to losing positions. As I often point out, you’ve got to listen to the market, not the message boards, analysts or management. A losing trade is, by definition, a weak stock. By adding to it, you’re exposing your portfolio to more concentrated risk at exactly the wrong time. In using stop-loss orders, you’re giving the market a chance to “prove” itself and move higher. But don’t throw good money after bad. A losing trade is the market’s way of telling us that, at least for now, we’re on the wrong track.

If XYZ is a winning trade in your portfolio, I think the general approach should center on trying to protect that position rather than cash it in. The market doesn’t know you bought it 10 points lower. When I’m asked about a trade someone holds as a winner, my instinct is to try and let it ride. In these cases, the real nuance comes down to adjusting position size.

Huge trades — those that make up 15% or more of your entire portfolio — shouldn’t be trimmed outright, but assigned with trailing stop-loss orders that, should the stock fall, quickly bring the trade down to a more appropriate size. Tiny trades, those meaningless positions that make up less than 1% of your portfolio, should be dealt with more severely. I believe they should either be given a full trade allocation or sold altogether. As I’ve written before, tiny positions simply eat up capital. Even if the stock rallies sharply, the effect will be minimal on your bottom line. If you don’t like a stock enough to have a 1% position, I don’t see a reason to include it in your portfolio.

Investors can calculate, chart, analyze and back-test forever, and yet the market is going to do what it’s going to do. While you can solicit other people’s opinions, it’s your own sound judgment that should guide our action. When evaluating a stock, it’s vital to distinguish whether you’re considering it for new purchase, or if it’s already in your portfolio. Each situation demands a unique approach.

– Originally on Jun 29, 2004 by Jonathan Hoenig

Free trade is one of those rights. As philosopher Ayn Rand wrote, “political freedom cannot exist without economic freedom; a free mind and a free market are corollaries.” People who aren’t free to trade their property, time or productive effort in accordance with their own values aren’t free at all.

Yet slowly, under the leadership of both major political parties, free trade has become systematically exorcized from civic life. Most citizens, the business community included, now completely accept that the government has a right to regulate, orchestrate and otherwise micromanage their affairs in any fashion it sees fit.

You now need government permission to open a restaurant, deliver a letter, drive a taxicab or become a dentist, just to name a few examples. Every piece of property you buy, every dollar you make and every worker you employ must duly be reported and registered with the State. In most cases, the process involves paying a tax or filling out a stack of forms that nobody will ever read.

While we pay lip service to freedom as being unalienable, we routinely permit free trade to be curtailed on the basis of public-opinion polls. It’s a reality that damages not only our economy, but the very philosophical framework on which our republic is based.

Take, for example, the minimum-wage law, an issue on which Senator John Kerry, the presumptive Democratic candidate for president, has been quite vocal lately. Kerry supports raising the minimum wage to $7 from $5.15 by 2007. President Bush, according to a spokesman, is also willing to consider an increase. It’s an issue that scores points with liberals, labor groups and anybody who doesn’t recognize that free trade is, in fact, free trade — not just a clever catchphrase or bumper-sticker slogan.

Minimum-wage laws don’t work. Like any government intrusion in the free market, they end up exacerbating exactly the problem they were designed to remedy. Because it is set by slow-moving bureaucrats and not the responsive free market, the minimum wage quickly becomes the maximum wage for entry-level, low-skilled workers. Of course the minimum wage isn’t a “living wage.” The only reason businesses can pay it is because the government do-gooders give them a perfect reason to.

The way to raise the standard of living in this country isn’t to boost the minimum wage, but to abolish it altogether. If businesses were allowed to compete in a truly free market, more low-skilled employees would be working, and more high-skilled employees would be working for higher wages. The work force would be more productive, and everybody would benefit.

Minimum-wage laws are economically detrimental, because they impede otherwise perfectly functioning market mechanisms. Yet the real reason to oppose them isn’t because they are unpractical, but because they’re immoral. A free market exists on the basis of voluntary exchange. Employees have the right to negotiate, accept or leave any job they choose. So if I indeed have a right to my life, then it follows that I have the right to willingly and consciously accept a job for any wage I see fit, even if it’s lower than the wage the government sees fit.

Any number of workers, from low-skilled laborers to soccer moms to other workers moonlighting off hours, might indeed want to take a job that pays less than the governmentally mandated minimum. And they have every right to do so. Yet it seems like the regulators would rather see a person not working for $4.85 than working for $5.15.

At the same time, employers in a free market are entitled to offer whatever type of wages or compensation they want. So if I own a business and want to hire an employee, then I have the right to offer to pay whatever sort of salary I choose. When the government allows the free market to work, both sides inevitably come to mutually agreeable terms. For both political parties, simply letting the free market govern wages seems, well, impossible. How did we fall this far?

Given that our wages and income are so tightly regulated, it stands to reason that we allow our investments to be controlled as well. Indeed, securities regulation is a growth industry these days, with no less than three separate government agencies vying for power, prestige and the chance to benefit from productive work they don’t have to do. Now that insurance companies, brokerages, mutual funds and accounting firms have been given a thorough shakedown, next on the list are hedge funds, which it seems are targets for regulation simply because there’s almost nobody else left.

The vast amount of misinformation regarding hedge funds is a direct result of — you guessed it — government interference in private, lawful, free trade. To start, most people seem surprised to learn that the term “hedge fund” does not describe an investment technique or a risk level. Hedge funds are simply private investment partnerships. Just like a mutual fund, or any business start-up for that matter, a group of investors voluntarily pool their money under the guidance of an investment manager. Hedge funds aren’t inherently volatile, risky or highly leveraged. They can be invested in anything from real estate to stocks, exotic options to plain old cash.

To suggest even for a moment that hedge funds are “unregulated” isn’t just inaccurate — it’s farcical. Hedge funds are one of the most regulated industries in the nation. They aren’t permitted to advertise, solicit business or be the least bit publicly visible. Whereas a strip-club operator can buy a huge billboard on the interstate, hedge funds are barely permitted to print business cards. Direct mail, Web sites, anything that would actually inform the consumer is strictly forbidden. To a law-abiding hedge fund, the First Amendment doesn’t even exist.

Because it is illegal for hedge fund to educate the public as to exactly what they do, we end up hearing only about the ones that fail, or on those infrequent occasions when fraud occurs. Whether it’s a cover story in a magazine or grandstanding politicians vowing greater controls, hedge funds are expected to take the punches but not throw them back. And that’s the way regulators like it — the more fear, mistrust and ignorance that exists about hedge funds, the more they are able to justify regulating them in the name of “the public good.”

Another central way in which hedge funds are regulated is that they are prohibited from accepting investments from “nonaccredited” investors, a patronizing term the government uses to describe anybody with less than $1 million in assets or an income of less than $200,000 over the past two years. It doesn’t matter if a fund invests in CDs or a checking account — it’s illegal for hedge funds to accept an investment from anybody not meeting the “accredited” investor criteria. It’s a hurdle that eliminates about 99% of the entire population. Considering that hedge funds have beaten most other investments in recent years, it’s more than a little ironic that the majority of the regulations that prevent most citizens from investing in them are enacted in the name of the “public good.”

Just as with the minimum-wage laws, government regulation of hedge funds is both practically and morally wrong. As was noted, the “dangerous” hedge funds from which the public needs to be protected have been resoundingly profitable for investors over the past few years. The vast majority of money lost in the financial markets, it turns out, has been lost in fully regulated entities. WorldCom was regulated, as was Enron, Adelphia and countless others. Regulation, it turns out, doesn’t eliminate fraud — it just makes it more difficult to detect. A company that meets government regulation is granted an implicit guarantee of safety. An unregulated enterprise has to be more transparent to attract and build public trust. Regulation allows a company to meet oftentimes very low minimums and be immediately considered reputable. And there’s no incentive to go beyond the oftentimes very arbitrary minimums.

Regulation also doesn’t stop incompetence — it cultivates it. Consider how many small and unsophisticated investors lost huge chunks of their life savings by investing with SEC-regulated stock brokers or in SEC-regulated mutual funds during the late 1990s boom. Because government regulation undercuts the free market’s competition for reputation, a fly-by-night operator is given the same credentials as the well-established professional.

The biggest by-product of regulation isn’t better qualified investment advisers, but more expensive ones, since the cost of compliance is simply passed on to the consumer. The only interests being protected are those of the regulators themselves, who without endless paperwork to demand and pages of rules to rewrite, would find themselves with little purpose for remaining on the public payroll.

Of course, the real reason to oppose further regulating hedge funds isn’t on practical grounds, but moral ones. More than any other country in the history of mankind, the U.S. stands as the international example of freedom, liberty and individual rights. The ability to invest, however and with whomever one chooses, is as inherently American as religious autonomy or freedom of speech. If a person’s life is his own, so is the product of his productive effort. Any restriction on how he may save, spend, invest or keep his money violates the basic principals on which this country was founded.

Forget Sarbanes-Oxley, the downright draconian set of controls that re-regulated financial service businesses back to the Stone Age. The real damage from Enron, WorldCom and the Nasdaq collapse will be felt over the next few decades, as the full effect of bigger government intrusion onto private enterprise finally begins to take its toll.

And the real tragedy is that what has changed isn’t our laws, but our attitudes. There’s now a consensus opinion that free markets, and indeed capitalism itself, are inherently destructive, immoral and criminal. The belief is that without “public servants” like New York Attorney General Eliot Spitzer or the SEC’s William Donaldson “protecting” the masses, business would run wild with fraud, looting America down to its last penny. Our population now accepts, by and large, that capitalism needs to be corralled, controlled and otherwise centrally planned.

It’s that philosophical shift that marks the end of freedom as we know it. And although a civilization doesn’t disintegrate overnight, you mark my words: The assault on free trade is what will eventually herald the collapse of liberty itself.

– Originally on Jun 22, 2004 by Jonathan Hoenig

In the investment world, our analysis is our map. The market can be dynamic, confusing and seemingly impossible to understand. It’s our analysis that turns chaos into harmony. In this game, the scenery is always changing. When you’re lost in the market, it’s disciplined analysis that helps you find your way.

Of course, there’s no shortage of indicators, reports and data points to consider. If you follow the fundamentals, there’s everything from revenue to price/earnings ratios. Technicians watch moving averages, relative strength, Fibonacci and other market minutiae too numerous to name.

The truth is that trading can be as complicated as you want to make it. And because of the sheer volume of statistics to consider, analysis can become paralysis real fast. But because you can’t focus on everything, you’ve got to focus on what matters, and that’s price — end of story.

I watch prices. Not the company’s breakthrough product, insider selling or the Strong Buy issued by the talking head who doesn’t own a share for himself. The price is what we trade, so the price is what I watch.

My basic premise is that the best way to determine a security’s future is to evaluate its past. So I ask, where’s XYZ trading now? Where was it last week? Last month? Last year? For me, prices are the market’s tea leaves, Ouija board and crystal ball all rolled into one.

Amateur traders watch prices too, albeit for exactly the wrong reasons. They are innately attracted to low-priced stocks, for example, lured by the prospect that a $1.25 stock will jump to $2 just a few hours after they’ve bought in. Conversely, they hate buying higher-priced stocks simply because they can’t buy a large number of shares.

Yet a stock’s price, the numerical cost per share, really doesn’t mean much. Using stock splits, a company can peg its share price just about anywhere. Without a reverse split back in 2002, for example, AT&T (T) would now be trading in the low single digits. And because Berkshire Hathaway’s (BRK.A) stock has never split, it trades at a hefty $89,000 a share. So a stock’s price in the abstract is meaningless; rather, it’s a stock’s price history that counts.

When I’m evaluating XYZ, I want to know its history better than a pair of well-worn flannel pajamas. Not just the current price, mind you, but everywhere it has traded in the past. What did XYZ look like during the bubble? The bust? How did it weather the collapse of Long Term Capital Management, the 1987 crash and other major events? By looking at price history, I try and determine when it was loved, when it was hated and when it was forgotten about altogether.

And because stocks tend to move in groups, any analysis of XYZ must include looking at similar companies within the same industry. Is the group’s price action bullish, bearish or somewhere in between? Have any similar companies blown up or recently become weak? What’s the strongest stock in the group? Is it in the sector leading the major stock indexes, or is it lagging behind?

There’s a reason it’s called “speculation.” Because no matter how much analysis we do, nobody knows what’s going to happen. While trading isn’t science, it’s not witchcraft either. For my money, if you’re going to analyze the market, then the best place to start is with the market itself.

The times in which I’m most successful are those in which I feel unequivocally knowledgeable about exactly what’s going on. The more intimately I follow prices, the more confident I am in my trades, because what’s reinforcing my market opinion isn’t an analyst or research report, but the market itself. It seems simplistic, but in an age when “research” has come to mean a positive mention by Lou Rukeyser or blurb in BusinessWeek, closely following a stock’s price history, for many investors, is a big step.

And the current market? Although I look at dozens of price charts every day, I still see little that inspires me to put new money to work. Stocks are up, but not in the consistent and orchestrated pattern upon which I believe strong trends are based. I’m not gaming the election or commenting on the war in Iraq; I’m watching prices. What I see is the choppy sort of environment in which both the longs and shorts end up churning themselves to death.

So although my eyes are wide open, my powder is still dry. When there’s money burning a hole in your pocket, the waiting is often the hardest part. I hate to be lost. So until I find a path I like, I’m resigned to stay out of the woods altogether.

– Originally on Jun 07, 2004 by Jonathan Hoenig

Much of what goes for research these days, so many of the data points that investors consider, is nothing more than superstition and coincidence packaged into feature-length column inches. I’m sorry, but the fact that it’s an election year, or that John Chambers thinks the economy is improving, or that New England won the Super Bowl has nothing to do with what’s actually happening in the market. And because it’s easy to get distracted, most people end up focusing their attention on the irrelevant factors they can’t control, and which have no direct bearing on the market or their position in it.

So while many investors weigh thousands of variables in evaluating the market, I consider a select few. To the best of my ability, I wear blinders, ignoring all the white noise and focusing on what matters. While I’m not always right in my decisions, I’m always well informed.

When the doctor asks you how you’re feeling, he doesn’t mean how you were feeling last month, or how you expect to be feeling next year, but how you’re feeling right now. To that end, the most influential factor to consider when evaluating an investment is how it’s acting at the time of your analysis. Determining security strength is my No. 1 priority.

The market isn’t chaotic. Just like the seasons, it moves in trends, which tend to persist over time. Therefore, a strong stock, one whose buoyant price action leads both its peers and equities in general, will tend to stay strong, often for months at a time. Weak or lagging stocks, no matter how big a value they might appear, have a tendency to languish, testing investors’ patience and, in many cases, solvency.

Of course, even the strongest investments won’t mean much if you don’t own a meaningful number of shares. So the second critical element to focus on is position size. That determines how ideas are actually executed within a portfolio.

The best place to start is at the beginning. So when it comes to allocating capital, I’m of the belief that all positions should start out the same size, a quantity expressed as a fixed percentage of an overall portfolio. Aggressive investors might consider 3% to 4%; more conservative ones should stick to 1% to 2%. The point is to eliminate the subjective speculation about which investments are “safe” and which are “risky.” Allocate the same initial capital to each, use diligent stop-loss measures, and let the market decide.

Sticking to a fixed percentage allocation for each purchase avoids having both “useless” and “suicidal” positions. Useless positions are those tiny trades that do nothing more than waste capital and commission expense. So in a portfolio of $50,000, for example, it makes no sense to have a $200 position. Even if it were to double, the effect on the overall portfolio would be negligible. If you don’t believe in a security enough to have at least 1% of your assets in it, then you’ve got to question why it’s in your portfolio to begin with.

Suicidal positions, as the name suggests, are the huge, foolish trades in which someone plops down 10% of a portfolio in one stock at one price. It’s a self-destructive gambler’s maneuver that almost always ends up with the investor turning a small initial loss into a fatal large one. Just as an acorn turns into on oak tree, positions should grow to be large — not start out that way.

One of the biggest mistakes regarding position size is to sell an investment simply because it has grown to become a larger portion of a portfolio. This exercise, usually called portfolio rebalancing by financial advisers, is a loser’s move that’s best avoided. Think about it: By selling the securities that have appreciated and buying those that have lagged, you’re getting out of strong stocks and into weak ones. And considering the market doesnt “know” where you got in, why trade away big positions in strong stocks? That’s precisely where the gravy is made.

A huge winner, of course, is a problem we’d all love to have. And when a position eventually grows to become a dominating element in a portfolio, say 5% to 8%, setting stop-loss orders below the current market price is the best way to protect gains while keeping the upside potential intact.

When it comes to investing, we’re all dumb money. But the dumbest among us is the herd, the perennially losing majority whose arrival usually signals the end of a money-making opportunity. What makes tracking the herd, my third key factor, so important is that although nobody’s always right, the herd is always wrong. The sooner you find out where it is, the sooner you can go somewhere else.

Unfortunately, the herd isn’t always that easy to spot. One of the techniques I use is monitoring message boards, such as those at Yahoo! Finance or other major stock portals. If I’m holding a strong stock and there are only a few infrequently posted messages, I’m more confident that the herd has not yet shown up. Once a board starts buzzing with dozens of messages a day, I can’t help but start to think the big move has already been made. The more breathlessly bullish the posters, the faster I start to head for the exit door.

Avoiding the herd is another reason why overloading on too much financial media can hurt trading more than it can help. So the reason I don’t watch CNBC or read BusinessWeek is because everybody watches CNBC and reads BusinessWeek. If I want to think differently, I certainly can’t be fed the same inputs. The best market indicator to follow, of course, is the market itself. The commentary I value is from experienced, informed market professionals who are, most of all, personally invested. If someone claims that XYZ is the next big thing, he damn sure better own a few shares himself.

The herd is like pornography: You know it when you see it. And because it’s often impossible to survey the entire group, I find it helpful simply to keep tabs on one of its regular members. The old saw on Wall Street is that when the shoeshine boy is talking about stocks, it’s time to get out of the market. The shoeshine boy is the fade.

We all have a fade, that one guy or small group’s opinion that, over time, seems to be dead wrong and woefully out of touch. Maybe it’s a relative, or it could be your mechanic, professor or even a good friend. It might be a columnist — Cough! Cough! — or a television personality.

The point is that you believe them to be card-carrying members of the herd, and generally wrong about the market’s condition. So you’ll fade, or take the other side of whatever trade they are choosing to make.

The fourth important factor that I think has a direct impact on trading success is mental health. I’ve said it before: Trading is a mind game in which you must be in a solid condition to compete. If you’re not in some type of pain, you’re not doing it right.

Because losses hurt, and yet are simply a cost of doing business, trading when you’re depressed, angry or distracted is a potentially disastrous move. Money management is an exercise in discipline under fire, and it’s at these emotionally vulnerable moments when people’s discipline tends to evaporate completely. So they’re mad at their spouse and subsequently day-trade away their nest egg in the QQQ (QQQ). Or a parent died and the son doesn’t cry, yet quietly begins selling risky naked options with his last 50 grand.

The most dangerous state in which to trade is when you’re broke, which is exactly why so many small investors are doomed from the start. The reason it’s called “risk capital” is because you’ve got to be comfortable with the idea of risking (read: losing) it. And not only is putting your last $1,000 in the stock market a terribly poor decision, but those who bet their last $1,000 tend to make very poor decisions about exactly how to bet. Inevitably, it quickly becomes an all-or-nothing Hail Mary pass that never gets caught for a score.

It’s the simple things that matter most. And although technology has changed the mechanics of trading, the fundamentals never waver. So despite the overload of information now available at a mouse click, I try to stick to the basics. And anyone who’s been around markets long enough will tell you sticking to the basics is tough enough.

– Originally on May 24, 2004 by Jonathan Hoenig