PREFACE
The Fate of the “Average” Investor

Countless times people call me up asking for help; however, their plea usually comes with the condition “I don’t want to spend a lot of time or do a lot of work because I’m just an average investor.” Is that you? Well, Joe Smith considered himself an average investor.

Joe retired in 2003. He had done well during his working years, and he had a retirement income of $6,500 per month, including Social Security. He had saved about $623,000 as a nest egg for emergencies in his retirement. He still owed about $350,000 on his house. Joe and his wife debated a lot about whether they should pay off the mortgage with their cash. The house payment was nearly $2,000 per month, and if they paid it off, they’d have plenty of money to spend each month and little to worry about.

Joe had lost about 30% of his retirement nest egg during the market crash from 2000 to 2003. However, in 2003 the market was going up. Joe figured the worst was over and that he probably could make 10% per year on his money. That would give them an additional $5,000 per month for spending, which more than covered his mortgage payment. Joe had an advanced degree in civil engineering, and, as far as he was concerned, investing wasn’t rocket science. He’d do well in the market because he was a smart guy. Chances are, he thought, he could be better than average and get his account back up to a million dollars (the way it was before the 2000 crash).

Joe made a mistake that many people make. He had spent nearly eight years learning his profession and much of his life staying on top of it. He thought he was smart enough to outperform the market professionals and make 10% or more each year as an investor in his retirement. After all, it just amounted to picking the right stocks, and he could do that.

Joe was now 68 years old. His total education in the market consisted of reading three or four books on how to pick the right stocks plus a book about Warren Buffett written by someone other than Warren Buffett. He also watched the financial news regularly, so he was sure he could make his fortune. He also read several financial newspapers each day, so he felt informed.

For a while, Joe was right. He made about $120,000 with his investment from 2003 through 2005, and he and his wife spent about half of that. Thus, Joe’s account at the beginning of 2008 was worth about $683,000. However, Joe was not ready for the second leg of the secular bear market. On September 30, 2008, the stock market was down over 40% for the year, and Joe’s account was down 29%—it was now worth about $484,000. If he paid off his house now, it would take most of his assets. When the bailout bill passed, he watched the market fall by hundred-point increments each day. Joe was really worried as his account balance approached $400,000.

The CNBC gurus Suze Orman and Jim Cramer said stocks would soon be a bargain: “Don’t sell unless you need the money.” Didn’t they realize that by the standard of just investing and holding, he was down nearly 60% from his equity high in 2000? In fact, Joe now needed to make 70% on his money just to break even on the year, and he was struggling to make 10% per year.

What’s the bottom line here? Joe had spent eight years getting his education to become a successful engineer, but he was treating the investing process as if anyone could do it. It’s similar to building a bridge without any training. You can’t work like that in the real world, but it’s easy to do in the market. In the real world, it could mean a collapsed bridge; when you do it in the market, it means the death of your account.

What does it take to trade successfully, especially in this market? Chances are that we’re in a long-term bear market that could last another 10 years. The United States as a country is bankrupt, and no one seems to realize it because we spend money like crazy.1 Trillions to bail out troubled debt is just a drop in the bucket. It could get much, much worse. J.P. Morgan has over $93 trillion in derivatives. Is any of that safe?

What happens when interest rates go sky high because there is no one to buy our debt? What happens when we have to pay for all of our unfunded future entitlements? What happens when the dollar is no longer the world’s reserve currency?

What happens when the baby boomers really need cash for retirement and there is a net flow out of the stock market? There will be a giant sucking sound coming out of the market! Are you prepared for that?

Ask yourself the following questions:

1. Do I treat my trading/investing like a business? Have I prepared for it the way I would for a business?

2. Do I have a business plan—a working document to guide my trading business?

3. Do I have a set of written rules to follow?

4. Am I following a regular procedure to prevent mistakes (a mistake means not following my rules)?

5. Do I have a tested system?

6. Do I know how my system will perform in different kinds of markets?

7. Do I know what kind of market we are in now and what to expect from my system in such a market?

8. If I don’t, have I gotten out?

9. Do I have exit points preplanned for every position I currently have in the market?

10. Have I developed specific objectives for my trading?

11. Do I understand that I achieve my objectives through a position sizing algorithm? Have I developed a specific position sizing algorithm to meet my objectives?

12. Do I understand the importance of the points above?

13. Do I understand that I create my own investment results through my thoughts and beliefs?

14. Do I accept responsibility for that creation?

15. Do I regularly work on myself to make sure that I follow the points above?

Circle all the responses that are true for you. If you haven’t circled at least 10 of the 15, you are not taking your trading seriously. Your financial health is in danger.

Here is what you need to do: Don’t accept the notion that you are just an average investor and there is nothing you can do. You create your own results, and your results right now come from playing a serious game with absolutely no training.

If you trade for yourself, you need to follow the guidelines in this book. If you do not trade for yourself but have professionals trading for you, do you realize that most of them must be 95% invested even in a falling market? They get paid 1 to 2% of the value of the assets they have under management. They get paid even if you lose money.

What about your open positions in the market right now? Do you have a bailout point for those trades? That is, do you know what a 1R loss is for you, where R is your initial risk? Or have you already hit a 3R loss (a loss three times bigger than you had planned) and are starting to ignore the market, hoping that if you don’t watch it, the fall will stop? Whose fault is it that you are ignoring the market?

When the market clearly has turned down, you should get out. The stock market was signaling a turn in 2007. Figure P-1 shows the trend of the market and at what point the market no longer was going up. This figure shows weekly figures for the S&P 500 since 2003. The 10- and 40-week moving averages are essentially equivalent to the 50- and 200-day moving averages that most professionals use. Note that the 10-week average crossed below the 40-week average in late 2007; that was a clear signal that the market had changed. That occurred at about 1,484 on the S&P 500 on March 3, 2009. The S&P 500 bottomed at about 670 on March 9, 2009—nearly a 60% drop from its high.

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Figure P-1 The S&P 500 through Mid-2008

There were other signs then as well:

• A head and shoulders top formed, although that was not obvious until about 1,400 on the S&P 500.

• If you had drawn a long-term trend line (since 2003), you could have gotten out at about 1,400 as well.

• There was an even steeper trend line that started in 2006 that was broken around 1,450.

• My market type analysis had been indicating that the U.S. stock market had been basically in a bear mode since January 2008 and that the bull market had ended and switched to a volatile sideways market in June 2007.

That’s plenty of evidence. If you had a plan to get you out of mutual funds when any of those signals occurred, you would be in good shape. But if you are an average investor, you probably haven’t put much time into studying the market. You just think you know what you are doing. What would happen if you tried to build a bridge or computer and put only that amount of study into it?

There is a well-known saying about how to make money in the market: Buy what’s going up, and when it stops going up, sell it. Unfortunately, most people listen to the opinions of others and cannot see for themselves what is happening. From April 28, 2003, through January 2008, my market classification model did not have a single week that was classified as bearish. The market was either bullish or sideways. Those were the times to be in mutual funds, as you can see in Figure P-1.

Furthermore, when the bear raised its head in January 2008, you did not want to be in mutual funds or any sort of long-term investing situation involving the stock market. Look at Figure P-1 and you can see that there were no significant bullish periods—unless you were day trading minor up corrections. You just have to look at the figure.

More recently, starting in March 2009, we’ve had one of the largest bear market rallies in the history of the stock market. The market (so far) has recovered more than 50% of its huge loss. My market type signaled that we had switched to neutral in early May 2009 and to bull market mode by early June 2009. However, by May 21, 2010, the market was moving back to bear market mode. See Figure P-2.

If you are a little more sophisticated, you can buy stocks that are going up and short stocks that are going down. Figure P-3 shows one stock, MYGN, that was going up throughout much of the bearish year 2008. From March through July, there was plenty of evidence that it was bucking the trend, and in July and August it was very strong.

However, short candidates were even better. Most of the darlings of the stock market before the disaster started to hit in July 2007 have plummeted. They include oil stocks, mining stocks, gold stocks, and even tech stocks such as Apple. All of them were good short candidates a long time ago, and most of them were not on the prohibited list of 799 that one could not short. From September 19, 2008, to October 8, 2008, the government had a list of prohibited financial stocks that one could not short.

By the way, the first part of learning to be a good trader/investor is to work on yourself. I’ve told many people these things over the years, but only the ones who clear away the trash in their minds (that is, non-useful beliefs and emotions that get in the way) are capable of seeing what’s going up and selling when it stops going up.

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Figure P-2 Market Type and Volatility Graph

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Figure P-3 MYGN

How about you? Are you going to continue to be an average investor and suffer the fate of other average investors? Are you going to say “No, this is not for me” and leave it up to professionals who will keep you invested even when the market is going down because they get paid as long as you keep your money with them? Or are you going to take the steps necessary to treat the handling of your money like a business?

For those of you who want to treat investing seriously, perhaps it’s time you got an education.

This book is divided into five parts, corresponding to the steps I ask people to go through in the Super Trader program at the Van Tharp Institute. The Introduction will give you an overview, and the rest of the book will give you many ideas and methods to help you achieve consistent profits in all types of markets.

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