Tuesday, September 29, 2009

A question of perception

The following is an excerpt from last weekends report. My point is to demonstrate the difference in how a smart money investor thinks as opposed to a dumb money retail investor.

"This weekend I’m going to do something a little different. An exercise in perception so-to-speak. What I want to do is try to relate how a professional investor thinks as opposed to how most retail investors brains work. In order to do this I’m bringing back our fictional characters John I. Que and Moe Ronn. I think you can probably guess who is the smart money and who is the dumb money.

First off let’s take a look at the gold chart for the last 10 months. I’ve made some annotations as to what’s going on in Moe’s brain as gold has bounced out of the low last year.

One of the differences between Moe and John is that Moe is constantly checking his account balance every day. When gold pulls back Moe freaks out and hits the sell button. He simply can’t stand to watch his account go down.

Browse almost any blog and what do you see? All of them are afraid of draw downs. Most will even brag about how they time their entries with tight stops so they never have to suffer any draw downs. The first thing I’ll say about tight stops is they are a recipe for multiple small losses. The pros can see those obvious stop levels just like Moe and they will invariably run them to get the dumb money to cough up their capital.

Moe is a classic dumb money investor - he buys high and sells low. The reason is because Moe is not in control of his emotions. On the contrary, his emotions are in control of him. So in order to buy Moe needs gold to rally enough for him to feel good about buying. He wants confirmation. Sound familiar? That’s when euphoria kicks in and the buy, buy, buy flood gates open up. Then, of course, what happens most of the time is Moe has jumped in just as gold has gotten overbought. Gold needs to take a breather. It pulls back and Moe, who’s constantly watching his balance sees his positions go into the red. Panic hits and the sell, sell, sell button is triggered. This is especially true if some kind of technical level is breached.

For some reason most retail investors place tremendous importance on charts and imaginary support and resistance levels. I suspect $1000 gold is one most amateurs are watching right now. I know exactly what’s going through their brains. Since gold was unable to hold above $1000 it means the rally is dead. Anyway, the end result for Moe is a loss. So the next time gold rallies Moe is slightly gun shy, he needs more confirmation before pulling the trigger this time. End result…round two of the Moe Ronn debacle unfolds. Repeat until Moe runs out of money or gives up.

Now let me show you how John I. Que thinks. For one he doesn’t watch his balance every day. He’s not concerned about a little draw down. Here’s what is important to John. The first thing John does is pull up a long term chart and decide what the secular trend is.

For gold it is obviously up. That revelation means two things to a professional trader. First, he wants to trade in the direction of the larger trend. Second, this is not a market that he wants to short. You will greatly reduce your odds of making money by trying to trade against the secular trend. In bull markets the correct strategy is either long or out. One doesn’t sell tops in a bull market. One buys dips. Any professional violating this very basic rule deserves to be fired and probably will be as soon as his manager spots him making this kind of newbie mistake. If you want to trade like the smart money you just don’t make these kinds of mistakes…ever!

So John has decided gold is in a bull market. Now let’s take a look at the 10 month chart and see how John’s thinking differs from Moe’s.
First off John would probably be buying close to the bottom as the COT was signaling extreme bullish readings. At this point John would recognize value and not worry about a draw down. John’s not trying to pick THE bottom. He’s buying value. Even if he doesn’t time the entry perfect he’s confident that eventually the market will come to its senses and reprice gold where it should be.

John continues to hold as gold tries to break through the 200 DMA. He has a pretty good cushion so he’s willing to wait and see if gold is ready to resume the bull run.

Once the 50 DMA crosses above the 200, and especially when the 200 turns up, John’s brain switches to full bull market mode. That means buying dips. So instead of freaking out every time gold gets oversold John is happily sucking up shares from the Moe Ronn’s of the world. He’s doing this because he’s now convinced the secular trend has resumed and he’s confident that any pullbacks are going to eventually get reversed.

At this point John is focused like a laser on building his positions in the ongoing bull market. Pullbacks are meaningless to him. In the meantime Moe is jumping back and forth trying desperately to stay on the hot trend of the moment. Normally with the results we’ve seen above. Buy high sell low. So while John is steadily growing his investments by concentrating on one thing, Moe is steadily shrinking his by trying to avoid draw downs and playing catch up with every hot trend.

One has to decide if they want to think like John I. Que and make money or do you remain in the ranks of the Moe Ronn’s of the world and continue to let your emotions run you around and around till you finally lose all your capital?"