Many people look at Apple’s price history and assume that most high-growth, momentum stories have a similar path – up and to the right; always recovering from their dips. Nothing could be further from the truth. The momentum universe is full of stocks like $YELP – they go up several hundred percent in a short period of time, reflecting market’s extremely high and often irrational expectations. Then when the market wakes up from its dream and realize that those stocks are not the unicorns it imagined, they give back 50 to 90% of their upside moves.
We dive a lot deeper into this topic in out latest book “The Next Apple“.
Financial markets live in the future. They constantly strive to price events that haven’t happened yet. Sometimes, they are spot on and discount what will actually happen ahead of time. For example, housing and home improvement store stocks started to break out to 52-week highs in late 2012 – long before economic data confirmed that there’s a housing recovery in the U.S. The market correctly predicted what was going to happen. By the time it was clear that the market had been right all along, most of the upside move in homebuilders was over.
By pricing events that haven’t happened yet, financial markets will occasionally discount events that will never happen. Markets are not always right. A stock could quintuple based solely on investors’ speculations and expectations for future profits. For example, 3D printing stock DDD went from $ 10 to 100 between 2012 and 2013. At the time, the whole world was excited about the possibilities that 3D printing could bring to manufacturing. 3D Systems did not live up to the expectations. The market became tired of waiting for the company to start making real money, and it sold the stock off in 2014.
Short-term price moves are based on sentiment. Long-term moves are based on earning power. The story, or more precisely, the expectations about a company have to come true at some point. Otherwise, disillusioned market participants will start to sell. The market is not always a brilliant, forward-looking mechanism, but it’s also not stupid or naïve, at least not when given enough time. In short-term perspective, it could be all of the above times 10 and create results that are both irrational and unpredictable.
You can’t catch a 20% move in a stock if you are not willing to lose 5-6%. This is often a normal pullback within many 20% moves. Sometimes, stocks that pull back 5-6% from your entry won’t recover and you will have to book a loss as a swing trader. It’s Ok. Being wrong is often not a choice. Staying wrong always is.
In the same line of thought – you can’t catch a 100% move in a stock if you are not willing to go through a 20% drawdown. Note that I say a drawdown, not a loss. Two different things. If you time your entry properly, you should never let your position drop more than 5-10% below your purchase – depending on the situation. Once your position is up for the races and you are already profitable on it, 10-20% pullbacks are often normal. Riding big long-term winners often requires going through deep pullbacks. Not everyone is willing or could stomach a 20% drawdown in individual positions. This is why not everyone could catch 100% movers. The good news is that you don’t have to if this is not your style. You could achieve just as good (and often even better returns) by going after multiple 10-20% short-term movers than by chasing unicorns. There is not right and wrong approach here. Both approaches could be very lucrative. Both could be practiced by the same investor. What you need to realize is that each of those market approaches requires different state of mind.
Brett Steenbarger is one of the most consistent and prolific financial writers, who is also a trader. I highly recommend following his blog TraderFeed and reading his books on trading psychology. Here’s a recent take of his on one way to develop your trading/investing acumen:
Find the people who most consistently come up with the most original and useful observations and ideas, study their thought processes (how they’re generating those ideas), replicate those ways of thinking for yourself, and take the time to begin thinking like them. Imagine doing that across many virtual mentors over time so that you begin to integrate the best thinking of the best people. That is how imitation turns into innovation.
Take a look at who you’re following in social media. If you’re spending much time reading material from those you don’t want to internalize, you’ll wind up with little cumulative development. A great exercise would be to curate the $STUDY stream of StockTwits and immerse yourself in the educational offerings of only those you’d like to emulate.
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