I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Wednesday Wealth, I write about money management, retirement, estate, and long-term care planning.
Investors swing between greed and fear, between euphoria and depression, whether about the stock market as a whole or individual parts of it.
Right now oil prices have pulled back from their highs, and oil bears are crowing on Twitter, “I was right!” I’ve seen some oil bulls admit they were wrong despite the fact that no one knows if this is a short- or medium- or long-term pullback.
I find myself swinging between euphoria and fear at the wrong times. Silver went parabolic? I’m in! Now the oil price is down? Sell all my energy holdings!
Greed and fear across the market(s)
In a memo to clients dated April 11, 1991, Oaktree Capital Management investor Howard Marks wrote:
The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward the extreme itself that supplies the energy for the swing back.
Investment markets make the same pendulum-like swing:
- between euphoria and depression,
- between celebrating positive developments and obsessing over negatives, and thus
- between overpriced and underpriced.
This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at the “happy medium.” (Emphasis added)
Right now, we see depression in the oil market, as algorithms and people respond to Trump’s announced deal with Iran. And we see euphoria in semiconductor stocks, as those same algorithms and people judge that the price of Micron, AMD, Intel, Sandisk, and others is going to keep climbing for the indefinite future.
In his book Irrational Exuberance, Yale professor Robert J. Shiller states:
Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases, and bringing in a larger and larger class of investors who, despite doubts about the real value of an investment, are drawn to it partly by envy of others’ successes and partly through a gamblers’ excitement.
These swings tend to go further and last longer than people expect but in financial history, every such swing to depression or exuberance has ended with a return towards the midpoint, and then a continuation to the other side. Of course with a specific stock, this may not be the case. Certain stocks never see swings of irrationality because they are too stable. And certain stocks go to zero, for example if the company goes out of business.
I’m talking about markets: the U.S. large cap market defined by the S&P 500 index, the crude oil market defined by futures in the Brent and WTI benchmarks, particular sectors of the market, such as semiconductor stocks.
What to do about greed and fear?
In short: come up with a system where you don’t have discretion to choose what to buy and what to sell, and when. Some investors use buy-and-hold investing for this: pick an allocation, perhaps across a set of passive index ETFs, and then rebalance to that allocation every quarter, or every year.
That didn’t work for me because I want to make decisions! But I’ve learned that the decisions I should make are about what my trading rules are, what kinds of trades I do (e.g., short puts, long calls? swing trades?), when to enter, and when to exit. Oh and of course: which tickers to trade. Don’t forget position sizing rules, diversification requirements, and exactly how much risk to take on across the portfolio.
I’ve done this with my options wheel trading and it worked really well, but I need to expand upon what I’m doing. I’m implementing a hedging system because selling cash-secured puts has unlimited downside risk that I don’t want to take on. I’m making my choice of which tickers to trade a lot more systematic, using a screener I set up in Tradingview and rules about when to sell a put on a particular ticker.
I’ve experimented with long calls and swing trades too, but it might be enough for now just to focus on the short puts plus the long put hedges.
Once I have this system working, I shouldn’t feel greed and fear. Instead, I will just know that sometimes my trades will pay off and sometimes they’ll get stopped out. Sometimes, similarly, my hedges will pay off but much of the time they will expire worthless.
This is a probabilistic way of thinking about trading. I don’t know what’s going to happen, but I can make guesses about it and give myself a probabilistic edge that should help me see good realized results.
Greed and fear begone!