It's often said that the market hates uncertainty. But plainly speaking, the market is uncertainty, endless uncertainty -- over earnings, interest rates, innovation, management and the countless other factors that help determine prices.
Every stock, bond, foreign currency or commodity has a bid and an offer, meaning that you can make a bear or bull case for literally any asset under the sun. But despite all of the research, high-powered computational analysis and review, we never truly know what's going to happen.
So while we can't control (or even reliably predict) the markets, we do have domain over our own portfolios, and have the ability to make ongoing decisions about how much to allocate to any one stock or strategy.
Because the best indicator of the market is the market itself, the logical approach toward mitigating uncertainty is to position oneself to follow the trend, not fight it.
For example, when stocks are weak, as they've been over the last few weeks as fears over Greece's debt implosion have resurfaced, it's our natural inclination to want to add to positions as they decline. It's the old "if I loved it at $50, I should love it at $45" routine.
But because we never truly know when a sell-off is on its way to being a correction or even a full bear market, the prudent approach is to avoid additional exposure to ideas that simply aren't working. A 6.5% decline in the S&P 500, as has unfolded over the past 3 weeks, isn't a reason to abandon stocks, but it is a good excuse not to add to them, at least until some of the lost ground is regained.
We make up a multitude of excuses why we should buy. Maybe it's because the stock is "on sale," which was said about Nortel, General Motors (GM)
All are rationalizations (and evasions) of the one fact that matters most: that stocks are weak. So why add to a weak asset? If you were riding in the Kentucky Derby, would you opt for the healthiest mare in the stable or the sickest?
The foils in human nature apply when investments move our way as well. So when the market is strong or we're holding a gain, we'll look for any possible excuse to snatch the profit, even though that's actually the last thing you should consider doing.
Just as we never know how far a market will fall, it's impossible to know how high a winning investment can climb, regardless if it's Apple (AAPL)
Yet once again we find a multitude of excuses why we should dump winning trades, from the notion that "the market needs a breather" to the oft repeated (but patently false) belief that "you never go broke taking a profit." In reality, you do go broke taking a profit when one's gains are continually smaller than the inevitable losses. That's what results in selling at the first possible moment.
So while many investors might not be comfortable adding to a winning position, all should get out of the habit of immediately selling a winning position, regardless of one's gut feeling.
In reality, we don't know what's going to happen to XYZ, but with a winning trade in our portfolio we do know that others are now paying more for the company's shares than we did, with the same expectations for gains that we had. It's then as we're finally in that position to exploit a meaningful move when many investors mistakenly trade their positions away. We end up making $300 on a trade in which we could have made $1,500 had we just held on a few days more.
Uncertainty is inherent in life and in the markets. And while we can't control what happens, we can marshal our own portfolios toward a better chance of extracting profits and defending against losses by basic portfolio management technique. When a position moves against us, the prudent approach is respect the tape, not reject it. And in those rare circumstances in which the market moves our way, investors should hold on and maximize those gains rather than immediately cash them in.
Sounds simple, but these elementary principles are the ones that matter most to the bottom line.—Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC