Chapter 33

Tough going

As I write this book in February 2013, we have been through three years of one of the more difficult sideways markets in my experience, at least since the last long one in 1988–93, after the 1987 crash.

When the stock market is rising most people make money, at least on paper. Even monkeys have been known to be able to make successful stock selections in strongly rising markets. Wall Street has a cruel saying about investors mistaking a bull market for brains.

Most investors then end up riding the stocks that they bought in rising markets down again in falling markets. Although most investors do not much like them, falling stock markets should also be easy to deal with. They simply require the opposite strategy to rising markets. In a rising market the trick is to get in early and stay in. In falling markets, the reverse applies. Get out early and stay out.

However, there is a third market condition that really is difficult to deal with and can be quite treacherous. This is when markets churn sideways. One moment they are rallying and the next minute they are falling, taking away any recent gains. We will hear investors complaining about breakouts that fail, and about their bad luck. The truth is that many investors underestimate how much of the time stock markets and individual stocks spend essentially tracking sideways.

In sideways markets, another saying comes into its own: when the going gets tough, the tough get going. This is a time when investors have to work for their money. In a rising market, any fool can make money. If they are half smart, they can also avoid falling markets. However, in sideways, trendless markets we find out which investors have developed the necessary skills and discipline to succeed. If sideways markets are the most difficult to deal with and we are prepared to deal with them, then if anything else happens we should be able to deal with that too.

The first step is that investors must have developed a plan for investing that includes sideways markets. They need to have thought through what they are trying to do and how they will try to do it.

In sideways markets, there will always be some stocks that continue to trend upwards. They will not always be easy to find and there will be many failures. The key to investing in these stocks is to have a very clear plan, with precise rules and guidelines, combined with an iron discipline to cut losses the moment the trend fails. In a rising market, to some extent the profits tend to look after themselves. In a sideways market, profits can be hard won and the key is not to let the inevitable losses outweigh the profits. In sideways markets, to some extent investors should forget about the profits and focus almost all their energy on avoiding losses.

One of the key strategic decisions that investors should make is what percentage of their investment capital should be invested in a sideways market. Interestingly, many investors never think about this. They just assume that they should always have all their money in the market. This belief comes from the propaganda put out by large fund managers who point out that if investors are not in the market on the 10 best days each year their return is fatally crippled. This claim is self-serving. Large fund managers cannot easily get in and out of the market, so they really have no choice. Moreover, their basic fee is a percentage of funds invested with them, so they have a strong interest in investors staying in their fund. However, the small private investor has plenty of choice. It is equally true that if we are out of the market on the 10 worst days, our return will be greatly improved. It seems to make far more sense for small investors to learn the skills to be in rising markets, out of falling markets and cautiously involved in difficult sideways markets.

Of course, it is easy to say that small investors should attempt to time the market. The catch is that they should attempt to do it only when they have learned the skills to know what sort of market they are in. It is not an easy thing to learn. However, it can be done through formal education, diligent study of the markets and experience.

Small private investors who want to give it a go need to borrow something from professional fund managers. In a word, they too must become totally professional. As already discussed, they must have a plan, but that is only the first step. The crucial bit is to monitor two things: that the plan is being followed and whether it is working. Professionals tend to keep excellent records of their investments. Amateurs tend to have a shoebox full of broker confirmations, which they hand to the accountant at the end of the year. This is not successful investing behaviour.

The best small investors emulate the professionals. They have records that are up to date at all times, so they can monitor how they are going for the year so far and take corrective action if they drift off course. Some even plot an equity curve, which is the daily or weekly value of their portfolio against the market index and against their target return for the year. If they are falling behind the market and their target, they start to look for what is wrong and review their strategy.

There is one other type of record that is just as important, especially for beginners: an investment journal or diary. This should record every investment decision, when and why it was made and, critically, how closely it was aligned to the rules in the investment plan. This requires some effort of will and discipline to do, but in my experience the rewards in terms of improved decision-making skills are very significant. It can be kept entirely private, or shared with a partner, as fits each investor’s situation. The key thing is that it is an honest record. Then, if the results obtained from investments turn out to be less than expectations, this journal can be analysed to check if the fault lies in the plan or in the execution of the plan. It will then be apparent whether the plan should be reviewed or whether renewed efforts are needed to follow the plan.

One final thought is that it is not generally possible to make as high a return in a sideways market as it is in a rising market. Therefore, it is important to ensure that the targeted results are realistic. This alone will save investors from unnecessary angst as they struggle to succeed in tough markets.

Summary

Professional investors tend to do better than small investors in difficult markets. While it can be difficult to survive in falling markets, small investors can stand aside. The really tough markets for small investors are sideways markets. Some guidelines for sideways markets:

• Have a plan specifically for sideways markets.

• Decide the level of participation. It may be better to be only partially invested.

• Keep an equity curve and ruthlessly evaluate performance.

• Keep an investment journal and interrogate it for lessons: especially whether the plan is being followed.

• Have realistic expectations for difficult markets.