Alpha Power Investing Newsletter

October 1, 2020

What It Takes to Succeed in the Markets

Investing is a game of "money" and "mind". In order to succeed in the long run, you must understand this simple principle.

While the reality is that it is possible to take a small amount of capital and build it and grow rich, the other reality is that the more you have the easier it is to make it grow. This is where "mind" moves front and center. If you are "betting the rent money" the likelihood is much higher that you will react emotionally somewhere along the way. And reacting emotionally when it comes to money is ALWAYS a mistake - even if things work out just fine "this time around". The mind remembers the exhilaration of a big money-making move and the pain of a fateful decision that costs you large sums of money. The mind instinctively craves more of the former and works hard to avoid the pain of the latter.

The problem with the mind in investing is that there are so many ways to go wrong. If you invest long enough there is a good chance that somewhere along the way you will get lucky. A trade you did not expect much from just so happens to play out in glorious fashion and you almost can't believe how easy it was to make so much. Therein lies the danger - the danger of seeking that feeling again and again. A person may suddenly find themselves chasing opportunities or ideas that they normally would not - and probably should not - consider.

At the far end of the danger scale lies the unexpectedly large loss. This often involves a "self-inflicted wound" whereby an investor makes an already bad situation even worse by throwing their own rules or guidelines to the wind ("I'll give it just a little more room before I get out" - right before the big overnight gap down, or some such scenario). Even if this investor survives financially, there is long-term emotional danger, as the pain of that one bad trade can linger for years to come, and actively trigger the "flight" response far too soon time and again. This can create a cycle of failure.

There are ways around all of this, although nothing is ever completely foolproof. The first step is to have a plan. A well thought out investment plan is something that virtually every investor would agree they should have. Yet the truth is that only a very small handful of investors ever really take the time to write out their investment plan. This is ironic - and quite sad - because such an effort can be empowering and can spell the difference between great financial success and average to below average returns.

The keys to investment success are to have the financial and emotional wherewithal to follow a well-thought out investment plan and to follow that plan. What should go into that plan? Let's delineate a few of the essential pieces.

How much capital are you going to commit in total?

What percentage of your capital will you commit to one individual position and what percentage of that capital will you actually risk?

How many positions will you typically hold at one time and what is the maximum number of positions you will hold at one time?

How will you decide how to allocate capital? Will you focus on large-cap, mid-cap, small-cap? Growth, value, low volatility, dividend payers? What about bonds, gold and real estate?

If you decide to invest in different asset classes, will you allocate a fixed percentage? Or will you focus on the trend of the relationships - i.e., allocate more to the best performing classes?

What will cause you to: a) enter a position; b) exit a position with a profit; and c) exit a position with a loss?

What about the tax implications?

There are two parts to the bottom line:

  1. An investor who actually takes the time to even think about specific answers to the questions above - let alone actually write it all out - gives him or herself a higher probability of long-term success.
  2. Most investors will never go through this exercise.

Dealing with "Money"
As alluded to earlier, the emotional pressure associated with investing "rent money" is great, and more often than not, can lead to mistakes and failure. The fear of losing money that you cannot afford to lose can typically be a catalyst for actually losing money.

So before investing - and every once in awhile along the way - investors should take the time to consider how best to minimize their living expenses and maximize their savings, so as to have as much money as possible to commit to investments. This does not imply that one should "live like a miser". It simply means that some serious consideration should be given to the tradeoff between "lifestyle and material things" versus having money available to invest.

In our day-to-day lives, we tend to focus a lot on doing things (experiences) and having things (material possessions). The human mind instinctively wants as much of both as it can reasonably attain. But the other part of the equation is "peace of mind". Each event and acquisition that costs money comes with a withdrawal from the other side of the ledger. Again, there is no magic balance. It is simply to your own benefit to do some serious thinking about how best to balance experiences/things versus the peace of mind afforded by a realistic sense of financial security.

You might be surprised to learn how many millionaires use coupons at the grocery store.

Dealing with the "Mind"
Fear and greed are the "big two" when it comes to obstacles standing between an investor and investment success.

Even for the very best investors in the world, investing typically involves a fair amount of ebb and flow. A lot of money is made, then some money is lost, then (hopefully) another big chunk of money is made, and so on. The trick is for the up moves to make more than the down moves lose. Unfortunately, an investor's emotions tend to rise and fall along with the equity swings.

When things are swell, the investment capital just seems to magically grow at a rapid rate. And the more we make, the more we want to make even more, and the greater the urge to "get greedy". This urge can manifest itself in any variety of ways, but the most common is to adopt a more bullish stance as things get more bullish, cavalierly ignoring the old adage that "trees don't grow to the sky". This can also lead one to take on ever larger positions and commit more capital as prices rise. The net effect is being fully committed - financially and emotionally - when the top is reached.

If you are walking down the street and you trip and fall, that is one thing. If you are standing on a mountain top and you trip and fall, that is something entirely different. And if you don't even realize that you are standing on a mountain top - and your gaze is fixed to the sky above, wondering how much higher you can go - the only words that aptly apply are "look out below".

The bottom line: Do anything and everything you can to maximize gains. But recognize that NOTHING (especially a bull market) lasts forever.

On the flip side, when things go south it is often a shock to the system. Market tops tend to take time to form. This is when complacency sets in and the typical investor waits patiently for the "next leg up". But when things go bad in the stock market, it tends to happen quickly. And just like that, all that money you had accumulated a week or a month ago is just a distant memory. Suddenly the investor is faced with a "fight or flight" dilemma: Hold on and hope to make that money back; or sell out and risk missing the next big advance. This is when answering the investment plan questions posed earlier serves an essential purpose. Emotional reactions cost you money in the long run - period. Maybe not every time, but in the long run, do not trust your gut to make intelligent decisions. Have a plan for how to handle risk and follow that plan.

One tip: Set reasonable expectations. If your analysis suggests that somewhere along the way your investment capital will experience say a 20% drawdown, then at the point the drawdown reaches 12% or 15%, the proper course of action may very well be to do absolutely nothing. But also know that if the drawdown exceeds your expectations and things are going seriously wrong, you may be required to act instantly and decisively in order to mitigate a potentially devastating situation. Another useful adage is "focus on the risk". If you take care of the risk (i.e., limit your losses) the market will take care of the gains.

One last point to ponder - how much volatility can you realistically stomach? Putting aside strategies and investment vehicles and buy and sell criteria, in the end, the volatility of the fluctuations of the equity in your portfolio may have a greater influence on your long-term investment success - and your peace of mind along the way - than any other factor. Roll too large and you expose yourself to potentially devastating risk, roll too small and you never accumulate a fraction of what you might have had you been just a bit bolder.

The battle for money is ultimately a battle of the mind. The keys to investment success then are:

  1. Form a plan that removes emotion from your investment decision-making process.
  2. Follow that plan.

Jay Kaeppel
Director of Research
Alpha Investment Management, Inc.

Disclosures and Disclaimers: The information contained herein does not constitute and should not be construed as investment advice, an offering of investment advisory services, or an offer to sell or a solicitation to buy any security. Before investing in any fund and/or strategy, investors should consider the investment objectives, risks, charges and expenses of the fund/strategy and its investment options.

Alpha Investment Management, Inc. is a SEC registered investment advisor located in the State of Ohio. Such registration does not imply a certain skill or training and no inference to the contrary should be made. The information and opinions expressed in this document are for informational purposes only. Any recommendation or opinion made in this document may not be suitable for all investors. The information contained herein does not constitute and should not be construed as investment advice, an offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

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