ONE OF THE toughest aspects of trading is that in order to make money, you’ve got to be right on a number of different fronts. Risk control, position size and timing must all be taken into account if you want to profit on stock trades. Of all these elements, timing tends to stir up the most controversy.
According to a recent and widely publicized study from research firm Dalbar, most mutual-fund investors are unable to time the stock market successfully. In fact, these investors aren’t even having much luck at keeping up with the rate of inflation. But as traders (read: active investors), like it or not, timing plays a role in investment decisions. Because it’s not just enough to know what to buy — the question of when to buy is arguably even more influential to the bottom line.
Most investors worry that they’re getting in at or near the top, especially in situations where a particular stock or sector has already risen substantially. Whether it’s low self-esteem or lack or confidence, they believe that as soon as the order hits the tape the market is bound to plummet.
Yet while it’s natural to feel as if we’ve missed the upside on a stock that’s done well, I find the more common tendency is to enter a trade too early rather than too late. And although at first it might seem preferable to buying the high, in this business being early is also known as being wrong. In my experience, trading stock is like going to a party: It’s often fashionable to be a little late.
Here’s why. Do fundamentals and valuation matter? I suppose. But let’s be frank: The point of this exercise is to buy XYZ at one price and sell it at a higher price. Stocks don’t have to rocket overnight, but they do have to rise. It’s hard to make money on a stock that isn’t moving in your direction.
And that’s one of the problems with buying stocks too early. Because as much as one might believe it’s just a matter of time before a weak stock turns around, the market often has a tendency to test our patience. Those investors who buy deeply out-of-favor issues solely on the premise that they’ll eventually come back often find themselves waiting far longer than they’d anticipated.
It’s much easier to determine when you buy a stock too late. Why? Because it’ll decline from your purchase price, perhaps even falling to a predetermined stop-loss level. Good risk control won’t keep you out of losing trades, but it will minimize the damage to your portfolio. And although nobody likes to have a loser, at least getting stopped-out permits you to move on to another, potentially profitable idea.
But when you buy too early rather than a little late, you resign yourself to waiting for a turnaround that could be months, or even years, in the making. With so many products and investment ideas to choose from, why should you focus on ideas that show no immediate signs of life? In my own experience, what I find usually happens is no matter how committed I am to waiting on a particular trading idea, after a number of months roll by, along comes another, equally promising trade.
And when you wait and wait on a stock that isn’t really moving, it’s not just your patience that’s being tried, but your pocketbook as well. That’s the other big problem with being too early — the opportunity cost of having one’s capital tied up in trades that are going nowhere fast.
As we often point out, you can’t invest in everything, and even in larger accounts nobody can afford to waste too much money on totally unproductive ideas. This is especially true in securities that don’t throw off interest or dividend income. When you’re too early in your trades, it’s seductively easy to find yourself sitting on a big chunk of dead money for months and months on end. The end result is that waiting on trades isn’t just boring — it’s surprisingly expensive as well.
Fear of buying the top is one of the reasons many investors tend to be too early in their trades. Another, ironically, is thinking too much. Many traders, especially the most educated, too often try to anticipate what they believe will happen rather than observing what is happening. Like a mirage in the desert, that often leads to seeing things that aren’t really there. So they don’t buy XYZ because it’s strong or because the group looks good, but because they think factory orders will improve which should stimulate the economy which should prompt better earnings for XYZ which should boost the stock price. The net result is they end up buying terribly weak stocks and sitting on them far longer than they expect.
We all want to buy the bottom, but as tough as it is might be, the approach I prefer in timing a trade is to wait until the stock has shown some objective technical strength before actually committing capital. Whether it’s waiting for a moving average to be crossed, a particular price level to be achieved or a specific trendline to be eclipsed isn’t very important. What matters in the discipline of technical analysis is discipline. Pick an indicator you feel comfortable with and stick to it. So if you’re interested in XYZ, make it show some strength before jumping in. Because as much as one wants to be early rather than late, you don’t need to buy the bottom of a trade in order to make money on a trade.
– Originally on Aug 04, 2003 by Jonathan Hoenig
