We’ve all made mistakes when investing, but I’m fortunate to have made fewer deadly mistakes than most. Let me tell you a story about how I lost 9.1% of my portfolio’s value in 3 and a half months, and what you can learn from my loss.
It all started in the beginning of June 2010.
From a fundamental standpoint, I clearly foresaw the dark economic clouds coming up ahead. I knew that the economy hadn’t really recover; it was QE1 (first round of quantitative easeing) that stopped the fall of stocks and lead the economy into an artificial recovery. I felt that stocks had risen too much and too high, so then was the time to go short. The fundamentals in the economy simply did not justify such high prices in the stock market.
I also didn’t believe that the Fed would initiate QE2 so soon. Even if they did initiate QE2, I thought the other investors in the market would see past the artificial recovery, and sell on the Fed’s supply of liquidity. Most investors indeed had seen that the upwards drive in stock prices was mainly due to the added liquidity by the Fed, and the real fundamentals had gotten better, but not enough to justify Dow 10k.
From the technical standpoint, stocks had reached a very hard to break resistance level in the S&P 500 1040 – 1080 level. Since stocks were stuck here for quite a while, I felt that it was time for a fall.
So I shorted the stock markets (I prefer not to divulge which particular stocks I shorted), having reason believing the markets would go down. I believed that from a technical and fundamental standpoint, prices were ready to fall . So I shorted the markets when the Dow was just a little over 10k.
3 1/2 months later, I cut my loss. My portfolio was down 9.1%. It was one of my most devastating losses ever.
Here’s what I learned, and how you can avoid a similar mistake like mine.
I thought the markets were being irrational. No matter what excuse I try to cover up my losses with, fact is fact. My market outlook was wrong, and I lost money. First, here’s what happened.
The Fed had initiated QE2 sooner than I thought. I’ve now learned that it’s pointless to fight against the Fed. However, I learned that lesson later than many other investors in the markets. I originally thought that the markets would fall, and QE2 would fail because stocks had risen too much, too high. Other investors also realized that stocks had risen too far, and should fall. But instead of fighting the Fed, they decided to go along with it because it was easier to make money following the Fed than going against the Fed. Stocks always follow the line of least resistance. But from this mistake, I learned one, very valuable lesson.
In the modern stock markets, there are two main forces. The investors, and the Fed. The investors follow the path of least resistance. Coincidentally, the path of least resistance is usually where the Fed wants the stock markets to go. In other words, most of the time the direction that the stock market is going and the direction that the Fed wants the stock markets to go is the same.
But the problem arises when the direction that the stock market is going is different from the direction that the Fed wants the markets to go. In such a case, it’s a battle of strength. Is the selling in the markets too strong for the Fed to hold up equity prices? If the selling isn’t too strong for the Fed to prop up the market, then prices will continue to rise. But if the selling is indeed too strong, then nothing the Fed can do will stop the blood flow, until the markets have exhausted itself of all the selling.
Stocks in June 2010 wanted to fall. That was for sure. But investors weren’t so frantic to sell as to the Fed not being able to hold up prices. Once investors realized that their selling notion was wrong, they decided to buy, thus driving prices higher and higher.
My point is, there are two main forces in the market. The market, with all the investors, and the Fed. Modern investing is purely a matter of predicting which side is stronger, and what the stronger side intends on doing (selling or buying).
When you’ve lost money, you’re wrong. Don’t be stubborn. Do you want to be right, or do you want to lose money?
The second important lesson that I learned from this mistake was that the economy and the stock markets often aren’t always correlated. Since the start of my short position, to the close of my short position, the real economy (not those “massaged” numbers the government throws out) hadn’t improved. Domestic consumption was still dismal, and the employment market was still dismal. Housing was no better. The fact that the economy wasn’t improving added to my dismal outlook on the stock markets.
Now I know that just because the economy is improving, doesn’t mean stocks will rise. Just because the economy is heading south, doesn’t necessarily mean stocks will fall. There is definitely a correlation between these two, but the economy and stocks often go in different directions.
The third and foremost lesson I learned is that one cannot completely depend on technical analysis. My technical analysis of indicators showed that stocks were ready for a fall. Technical analysis is the use of historical market data to predict the future. The problem lies in the fact that the past doesn’t exactly repeat itself. Hence, technical analysis should only be used as a guideline, not as the main source of your market analysis.
Thanks to Sinclair89 for commenting that timing should also be an important part in creating stop loss orders.