All-or-Nothing Bets on Market Destined to Fail

A major impediment to that flexibility is an "all-or-none" approach. Of course, larger traders know all-or-none as a type of order that stipulates that it must be filled completely or not at all. That isn't a problem, though I rarely use all-or-none orders. Rather, it's the all-or-none mentality of trading that seems to infest investors of all sizes.

Life isn't composed in black and white, but shades of gray. That's why the all-or-none approach, especially when taken to its big-swinging logical extreme, will hang a trader regardless of his investment prowess. It perfectly exemplifies how technique, much more than security selection, most impacts the bottom line.

For example, it's no secret that emerging markets have garnered great interest and investment dollars in recent years. Some investors have been bullish on Brazil, others on Turkey or the Middle East. All have generally done well, outpacing stock returns in the U.S.

As the trade has continued to perform well, many investors have become complacent, believing that emerging-market equities were all they needed to own. So they buy iShares MSCI Brazil Index (EWZ), iShares S&P Latin America 40 Index (ILF), iShares MSCI Singapore Index (EWS) and iShares MSCI Emerging Markets Index (EEM) — and considered themselves as owning a broadly diversified portfolio. Not exactly.

Back in 2001, I wrote about the diversification delusion, or how, during the technology bull market, many investors thought diversification meant owning Sun Microsystems (JAVA), Cisco Systems (CSCO) and Microsoft (MSFT). The same all-or-none lethargy has come to dominate many stock portfolios in recent months, with investors owning foreign stock ETFs and nothing else. In reality, given their increasingly close correlation, owning four different emerging markets isn't that different from owning one.

Beyond the types of stocks you buy, the all-or-none attitude often affects the methods by which you buy them. For example, I know plenty of traders who subscribe to newsletter services that issue buy and sell signals on major ETFs. These timing systems suggest you should buy or sell based on technical triggers. At any point, they're either long, neutral or flat. The idea is to follow their signals to achieve better-than-market returns with less-than-market risk. You generally go 100% long or short depending on their outlook.

That's the real rub. Regular readers will note how I always talk about planting acorns, investing a modest amount of capital and allowing it to grow over time. But all-of-none thinking forgoes acorns for glaciers. And if you're looking to play the S&P 500 for a modest 5% move higher, then yes, you've got to have darn near close to your entire capital base at risk.

The problem with making such large bets is that it doesn't take much to knock, or at least scare you out of a trade. Even when allocating 100% (or close to it) of capital to a diversified index such as the S&P 500, a 5% to 10% decline can be exceedingly difficult to recoup. And because your investment strategy consists of simply waiting for a bounce, there's not much one can do in those cases except cross your fingers and pray. Not a winning approach in my book.

Just as the all-or-none fallacy can sabotage us when buying stocks, so does it apply when selling them as well.

As regular readers know, it's my belief that when an industry in which I have an interest becomes legitimately weak, the first instinct should not be to increase exposure. If you're losing money, that's the most obvious evidence of how, at least for the time being, your outlook is flawed. So don't think for a minute that "the market has it wrong." The market is never wrong, but cocky investors often are.

When a holding is showing a significant loss, I might not sell it immediately, but I certainly don't throw good money after bad by upping my exposure. If we liked it at $50, then why in the heck is it now trading at $40? That's usually a bargain you simply don't want.

This is why I think the notion of "portfolio rebalancing" popularized by stock brokers at large institutions is asinine. When your stocks go up, they sell your stocks and buy more bonds. When your stocks go down, they sell your bonds and buy more stocks. In effect, it's a strategy of systematically selling winners and adding to losers. That's not my type of approach.

So when banks begin to break down, as we noted back in June, the all-or-none approach would be to dump every bank you own wholesale. But as several astute readers have pointed out, even during the carnage of the past few weeks, a select number of financial stocks have held up, including State Street (STT), Banco Santander (STD) and, most surprising to me, Bank Hapoalim (BKHYY), the Israeli bank in which my fund holds an interest.

When a market weakens, I think the correct response should be to play defense, but not necessarily run for the hills. On a few rare occasions, you're lucky enough to preserve those one or two names that actually weather the storm quite well.

When it comes to choosing, buying or selling an investment, all-or-none tends to be a losing approach. In selecting investments, it leads to overweight portfolios devoid of diversification. When putting money to work, all-or-none encourages big positions that either stop or spook you out of a trade. When selling out, the approach will oftentimes lead you to throw out the wheat with the chaff. All are reasons why, when it comes to managing your portfolio, subtlety and nuance are a must.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in some of the securities mentioned.