Apprenticed Investor: Expect to Be Wrong



Apprenticed Investor: Expect to Be Wrong

[pic]By Barry Ritholtz

In the present-day realm of investing, the near obsessive focus on stock selection has obscured the "art" of investing. There is much, much more to buying and selling stocks than mere stock picking. Not that you could tell, based upon what's in the financial media.

This new column -- "The Apprenticed Investor" -- is all about making you a better investor. Not just a better stock picker, but someone who knows how to preserve capital and manage risk.

One of the keys to successful investing is recognizing the frequency of "strikeouts" -- and having a plan in place to deal with them. This is the first lesson most new investors fail to digest.

I am rather frequently -- and on occasion, quite spectacularly -- wrong. But I expect to be. No one really knows what is going to happen in the future, so why pretend otherwise? When you anticipate being wrong, it makes it that much easier to both plan ahead and manage risk. There's little ego tied up in the position to prevent you from jettisoning it -- provided you have planned for the worst.

For the record, I do not yet consider myself a "master" -- not in the classic sense of the word: In the Middle Ages, anyone who wanted to learn a craft had to first apprentice. After many years of struggle and hard work, apprentices would toil their way up to "journeyman." Once a journeyman demonstrated a degree of expertise, he would be invited to join the guild, thereby becoming a master.

As a member of the guild, the master was expected to pass on his skills to the next generation of apprentices. This was how a craft was kept alive and growing. That's the inspiration for this new weekly feature.

Coming Up Next

Over the next few weeks, we will review the traps, pitfalls and common errors that befall all too many investors. We will disassemble the damaging myths that keep haunting individuals. My list of investing "pet peeves" will get some airtime.

We will dissect the reasons why stocks go up and down; it's actually simpler than most people realize. We will look at the debate over the "fundamental vs. technical analysis" issue. But it's not simply abstract theory: We'll go over "sell signals and stop-losses" -- a very basic yet overlooked tool. We'll look at "long-term" investing -- is it dead? Was it ever really alive? The answer will surprise you.

There are several important concepts that get almost no media coverage -- we will attack those. Managing risk will be a prime focus, including how you can trade even "fiasco" stocks -- like Enron and WorldCom -- yet not get destroyed.

The intriguing issue of investor underperformance will get some ink (pixels?). I'll show you why human beings simply aren't hardwired for the capital markets. Once you become aware of your limitations as a member of an occasionally rational but often emotional species, it will change your thought process.

We'll also spend time on the "don't" category. I'll discuss the five "investor types" you must avoid. You may be interacting with any one (or more) of these types; they are simply bad for you and for your investing. We'll go over some of the worst things investors say. These excuses lose people money -- and they don't even know it.

I also hope to convince you why you need not own the stock of your favorite company. It's a peeve I call "love the company, hate the stock." (This one freaks people out.)

We'll get to other subjects as they come up. This is an interactive media, so I'm more than willing to tackle your questions.

Finally, many investment "experts" make outrageous promises of untold riches to perspective clients. Here is my more realistic pledge to you: Spend 15 minutes per week with me on these pages, and I promise you that one year from now, you will know much more about how the markets work; you will have developed your own logical set of personal investing strategies; you will have learned disciplines that help you through all types of markets. In sum, you will have that many more arrows in your investment quiver.

And it is my hope that you will have made the transition from apprentice to journeyman investor.

P.S.: For the record, I actually reserved the URL "" years before the reality TV show phenomenon.

Apprenticed Investor: Your Fault, Dear Reader

[pic]

"He who blames others has a long way to go on his journey. He who blames himself is halfway there. He who blames no one has arrived."

-- Chinese proverb

In the first installment of "The Apprenticed Investor," we discussed why investors should expect to be wrong, and most importantly, having appropriate plans for what to do when you are wrong.

That column gave you two lessons disguised as one. Hidden within was a second, subtler message. It is so obvious, yet so ignored by investors: You are ultimately the only person responsible for your investments.

That sounds pretty straightforward, but for some reason it seems to be a problem in our society. Few want to take responsibility for their actions or situation, if they can avoid it.

Think I'm exaggerating? Every kid who does poorly in school gets diagnosed with ADHD. We are fat because of McDonald's (MCD:NYSE - news - research). There are shootings because of TV violence.

In sum, it's easier to pass the buck than to admit the truth.

Bad Excuses for Poor Investments

At times, the excuse-making from investors is even worse. Over the years, I have heard every complaint imaginable for why losses occur. Inevitably, these gripes go something like this: "It's not my fault but the fault of:

• The analyst who recommended it.

• The banker who did the deal.

• CNBC, which hyped it.

• The talking head who loved it.

• My brother-in-law, who got a hot tip on it."

I've heard people complain about their broker's bad advice, the lousy execution they got, and how a market maker or specialist hurt their trade. Other kvetches? Management stinks, insiders are dumping shares, regulators are overzealous. Margin calls did it. Or was it the president's policies or congressional gridlock or Chinese imports? Really, who can trade when the economic data are cooked, and the "Plunge Protection Team" counters your best positioning?

I've overheard people complain that they lost money because Alan Greenspan raised, lowered and/or left rates unchanged. Oh, and Eliot Spitzer, too.

Well, folks, I've got some bad news for you. None of those are the reason any of you lost money. The dirty little secret is much simpler. You lost money because you bought a stock, and that stock went down, and then you sold it. Period, end of discussion.

Buying high and selling low is a lousy investment strategy. Worse is buying high and not selling at all as (paper) losses mount. Think of Lucent (LU:NYSE - news - research) or Sun Microsystems (SUNW:Nasdaq - news - research) or Nortel (NT:NYSE - news - research), or the slew of stocks that went to zero. Too many people rode 'em all the way down, rather than admit a mistake and take responsibility.

You see, with responsibility comes a natural tendency toward planning. If you buy without a plan in place for when things go south --- when your original thesis turns out to be wrong -- then you are at fault.

Sorry to be the bearer of this bad news, but the sooner you start accepting that simple truth, the better off you will be.

Why? Because all of the excuses above are foreseeable events that only investors (and fools) fail to anticipate. Analysts can be wrong, TV is about ratings, insiders sell, and talking heads talk. Is that a surprise? Hey, guess what? The Fed raises and lowers rates, the FDA pulls drugs, and attorneys general prosecute.

Review some of the aforementioned complaints, and you will see how foolish they sound. Now try this one: I lost money because I made a bad investment. I lost a lot of money because I made a bad investment without a contingency plan for when things went wrong.

Here's the only excuse I would accept from an investor: Aliens from Alpha Centauri landed on earth and gave a huge technological secret to the rival of the company whose stock you own. OK, when that happens, you are excused. Short of that, everything else is your own responsibility.

Priorities and Homework

Excuses are just a sign of how lazy we all are (me too), including boredom and procrastination (guilty). If we are going to be investors, then we must do all the heavy lifting that's called work. If it were easy and painless, then everyone would be a fabulous and wealthy investor. But it's not, so you have to outwork and outhustle the next guy.

Recall that Michael Jordan didn't initially make his high school basketball team. After that, he swore he would never be outworked by anyone ever again. He went on to become the greatest player ever. There's a lesson in that.

We all know guys who can recall every baseball stat of their favorite team off the top of their heads; win-loss records, slugging percentage, ERA. Ask them about the top five holdings of their mutual funds, and they look at you as if you have two heads.

Some people spend more time investigating the purchase of a refrigerator than they do a stock or mutual fund. You have to wonder why people put more time into planning their next vacation than they do their retirement. A vacation is two weeks long; a retirement can be 20 years. There is something wrong with the math here.

The Freedom of Responsibility

Not to get all Zen on you, but once you accept this, there is a certain exhilaration in the concept. Suddenly, planning for your own retirement takes on a different hue. You become more focused, motivated and excited about learning.

Short cuts (i.e., stock tips) make you laugh. When other traders whine about their bad luck/the Fed/market makers, you can snicker to yourself at how they are fooling themselves.

As the magnitude of the awesome responsibility of taking control -- and responsibility -- sets in, it tends to sharpen the mind. It is empowering.

I think Spider-Man may have gotten it backwards: With responsibility comes great power.

Apprenticed Investor: The Wrong Crowd

By Barry Ritholtz

Has this ever happened to you? You've been waiting to deploy some fresh capital. You've done your homework -- checked the charts, looked over the fundamentals. You are ready to make a buy.

But moments before you pull the trigger, someone casually mentions something negative about this new target. It could be a coworker or some talking head on TV. Regardless, you hesitate, decide to do some more research, just to be sure ... and the next thing you know, your stock pick is off to the races -- without you.

All you can think is, thanks for nothing, buddy.

We've all had chance encounters like this. They can cause self-doubt, make you second-guess yourself, wreak havoc with an investment strategy.

There are two solutions to dealing with this kind of distraction: One is to become more confident in your own skills. This will occur as you continually educate yourself, which is what "The Apprenticed Investor" is all about. The more confidence you develop, the easier it is to stick to your investment plan and not let third parties bump you off track.

The other solution is simpler: Learn to recognize destructive investor personalities -- and stay as far away from them as possible.

Last week, we discussed why gains and losses are ultimately the investor's responsibility. But there are some people who can temporarily knock you off your game: These are people to avoid.

The Dirty Half-Dozen

• The Enthusiast: He's always breathless; his companies are always on the verge. "Big news is due any day now." There's always someone about to "snap these guys up." He's entranced with new management, i.e., "The new CFO was employee No. 12 at Dell (DELL:Nasdaq - news - research)!".

At one time or another, we've all been bitten by the infectious salesmanship of the enthusiast. The story always sounds great ... yet somehow, the stocks never seem to work out.

• The Tipster: The easiest of all the archetypes to recognize, this guy always has a hot story that simply cannot wait. It's about to happen any minute -- a deal to be announced or an imminent takeover.

While the "enthusiast" is all excited about the company, what gets the tipster jazzed is the source of info. "This guy I know is (choose one) head trader at a hedge fund/runs a major wire house d esk/at the FDA/on the board of directors."

Last year, biotech was hot and the tipster talked a lot about new drugs that were just about to get FDA approval (none worked out). Lately, the tipster has been big into government and military contracts; apparently, he gets to brunch with Donald Rumsfeld.

For a person who supposedly has information that -- if true, is likely illegal -- the tipster's trading record is surprisingly bad. With all of his connections and illicit info, it turns out that the tipster is little more than a rumor monger -- and one who's usually late to the party at that.

• The Liar: Most industries have their fair share of B.S. artists. But there is a very special type of liar attracted to trading.

You know these guys; they never seem to have a losing trade. When they discuss their executions, they consistently manage to buy at the low tick of the day. When they sell, their executions invariably are the very best possible print -- and on almost every sale.

Think about how often you've managed to get the very best print of the year -- or even the day. Over the past decade, I can count on one hand the number of times I've top-ticked stocks on the way out: Iomega (IOM:NYSE - news - research), Micromuse (MUSE:Nasdaq - news - research) and Qualcomm (QCOM:Nasdaq - news - research). Meanwhile, I've had countless sells at the day's low print.

Somehow, the liar manages to accomplish a decade worth of statistically aberrant prices each day, before lunch.

I never call these clowns out. Why show your hand? But I make a mental note who the liar is, and judge all future statements accordingly. You should do the same thing.

• The Permabull or Permabear: Among the most dangerous and costly clowns in the circus, these guys are responsible for more destruction of wealth than any other player.

You doubtless recall the permabulls from the late 1990s. Most are little more than slick salesmen. They do not do much in the way of original research, but you can imagine the inner workings of their minds, sifting through reports looking for just the right bullet points.

The permabull uses all of the right buzzwords, his patter is polished, his manner impeccable. By the time he's done with his bullish sales pitch, you're reaching for your checkbook -- and historically, big trouble.

Some of the permabulls used to be on TV a lot. One in particular was a frequent TV guest, extolling the virtues of the Goldilocks economy and the ever-rising bull market at Nasdaq 5000. Then the bottom fell out, taking the Nasdaq down a mere 80%. He never changed his tune the entire way down.

On the flip side are the permabears, of which there a few classic examples. They've been bearish for as far back as I can remember. They may have avoided the drop from Dow 11,000 to 8,000, but they've been waiting for that drop ever since Dow 3,000.

Avoid these broken clocks like the plague.

• The Exotician: The more obscure, the better: that's the motto of this creature.

Fascinated by exotic charts and little known indicators, the exotician changes methodologies as often as he changes his underwear.

Flitting from style to style like a butterfly, his enthusiasm for the esoteric merely masks the lack of conviction he holds for his previous theory.

Last week it was a combination Bollinger Bands and McClennan Oscillators. Before that it was Elliot Waves. This week, its MACD and Fibonnaci. Next month, it's the Kondratiev Long Wave theorem.

It's not that these techniques don't have value, but the exotician simply can't seem to stick with any one long enough to test their validity. The exotician is on a futile search for the magic elixir -- which, unfortunately, does not exist.

• The Know-It-All: I love listening to people talk about stocks at cocktail parties. One of my favorite players is the guy who knows all the obscure details on a company: When they were formed, who sits on the board, the model numbers of new products, all sort of useless minutia. At his fingertips is an unholy checklist of data, all of which is completely irrelevant to the investment process.

This is especially true with tech companies. Their products are complex and ever-changing; the networks they sell into are even more complicated. The technical attributes of their products are way beyond the comprehension of the average investor whose VCR clock has been flashing "12:00" since 1994.

Actual language overheard at a barbecue last summer: "Wait till you see the new 2200 dynamic cross circuitry router -- it's going to kick Cisco's (CSCO:Nasdaq - news - research) ass."

Now, I'm pretty tech savvy: I hooked up my own TiVo (TIVO:Nasdaq - news - research), and I can swap out a hard drive or add RAM by myself. But comparing the technical attributes of high-end switching equipment, and then doing a cost benefit analysis of the technical advantages of that product line (relative to the rest of the marketplace for that equipment) is far beyond my expertise.

I'll wager it's beyond your ken also.

Be wary of these characters. They remind me of the kid in grade school who couldn't hit, throw or field, but he memorized the stats of all the players on his favorite baseball team.

Folks like that often lack an appreciation for the game. It's no different with investing.

Apprenticed Investor: Bull or Bear? Neither

By Barry Ritholtz

I had an entirely different column in mind for today. But the events of last week were so peculiar, and so revealing of another classic investor foible, that I shifted gears.

This will be one of the few Apprenticed Investor columns written in response to current events. I'm doing so because I feel it's necessary to address last week's topsy-turvy market action. More specifically, the investor reaction to it.

A brief background: In my day job, I advise institutional investors on the state of the markets. When risk, according to my metrics, has risen unacceptably relative to reward, I become cautious. When the reverse happens, I get more aggressive. This has been my style for some time, and it works for me. Once I explain the process, I'll lay out the mistakes the public makes in reaction to these market calls.

'Are You a Bull or a Bear?'

I've heard this question countless times the past few weeks. And I find it a stunning rejection of Darwinian logic that proponents of such blather have managed to evade extinction. Investors simply never get asked a more distracting and pointless question. Effective investors find their style, then read the market and adapt accordingly.

Of course, in discussions about Wall Street, the bull and bear are mesmerizing. How often do we hear a newscaster somberly intoning: "The bears got gored by the bulls on Wall Street today..." The very next day, we hear the same talking head reverse course: "On Wall Street, the bears came out of their caves to chase the bulls, as the Dow dropped..."

The markets we saw last Wednesday and Thursday are textbook examples of why the colorful imagery of the bulls and bears is magnetically attractive to copywriters and repellent to good investing.

Why is this such a problem? Because of the "folly of forecasting": Once people commit to a position, there is an unfortunate tendency to root for that perspective. Even worse, people stick with their forecast, regardless of what is actually happening in the market. We addressed this in the very first Apprenticed Investor, Expect to be Wrong. But instead of preparing, people dig their heels in and cost themselves money by being more concerned with trying to be right rather than making money.

Surely, there are cheaper places to look for validation than the stock market.

Bull and Bear, a Matched Pair

In a firm I worked at during the bubble years, many of the brokers had bulls on their desks, but no bears. I used to take away their bulls, and refuse to return them unless they promised to display the bear also. I did this to prove a point: There are two sides to every market.

If you ever meet a money manager/broker/financial adviser who only has bulls displayed, run -- don't walk -- to the nearest exit. Why? Because it reveals a fundamental lack of market understanding: Markets go up and down; the bull and the bear each have their day.

And that's why the bull or bear question is inane. Stockholders should be watching market signals, economic issues and corporate earnings, with an eye toward adjusting their risk profile and investing outlook. Why? Because just like markets, risk goes up and down also. But once an investor commits to the bull/bear question, it leads to the unfortunate tendency to cheerlead for their last call rather than focusing on protecting capital. This very quickly can become an expensive hobby.

Red or Green: A Case Study

Here's a hypothetical example: Let's say you have a few errands to run that will require your driving a car. Before you turn the key, decide the following: Are you a "red" or a "green?"

You have to be something, so pick one before you leave the garage.

Now, apply that choice at every signal you hit on your errand. If you're a red, come to a dead stop at every signal. If you are a green, just drive through the next red light. When the cop asks why, just tell him it's because you are a "green." (Good luck in court).

Clearly, this is absurd. Rational people observe the color of the light, and step on the brake or accelerator as appropriate. Yet when it comes to the markets, many otherwise rational people do just this. They have predetermined their intentions and invested their dollars -- regardless of the many signals the broader market gives. One need look no further than recent history to see that ignoring market signals is a recipe for disaster.

Let's say you are a bull, and the Fed is tightening, corporate earnings are sputtering, the yield curve is inverting. Do you drive straight through the red light, going aggressively long the Nasdaq-100 Trust (QQQQ:Nasdaq - news - research)? Or do you notice the signal?

Now imagine you're a bear and sentiment is at an extreme negative, year-over-year S&P 500 earnings have gone from bad to so-so, and the Fed is cutting rates. Do you stop at the light, shorting the Spyders (SPY:Amex - news - research), even though it's bright green?

Savvy investors get long or short (or move to cash), as conditions dictate. When all the signals line up in the market's favor (regardless of style (valuations, sentiment, monetary policy, etc.), the smart investor gets long. When the indicators line up the opposite way, that investor gets defensive.

The terms bull and bear are anathemas to me. You can be long or short or mostly cash at various times -- sometimes all at the same time. So why commit to dogma? The market does not require you to declare your party affiliation or sign up for a religion. "Are you now, or have you ever been, a bear?" is not a question on a new account form. If there's a perceived advantage to being bearish, you should get bearish and vice versa.

Now, on to the public's reaction to bearish or bullish calls: One of the typical emails I get, particularly after making a bearish argument is: "In the long run, doesn't the market tend to go up? Isn't that reason enough for a bullish bias?"

It depends. If you bought stocks in 1966 when the Dow first hit 1000, well, the long run hardly bailed you out. The Dow didn't get over 1000 until 1982. How'd you like to spend 16 years and end up with a precisely 0% annual return? And that's before factoring in inflation.

The problem with the so-called long run is that it overlooks the here and now. "This long run is a misleading guide to current affairs," wrote John Maynard Keynes in his seminal 1923 work, A Tract on Monetary Reform. "In the long run," Keynes noted, "we are all dead."

It has also been an excuse for some terrible advice. Example: "Buy and Hold" works well during some periods (1982-2000) and poorly during others (1966-1982; 2000-2005). If you noticed a pattern here, you are already ahead of the herd.

Adaptability is the key to surviving these longer-term cycles of boom and bust. It is important to have a degree of sensitivity to changing market and economic conditions. Once you recognize a transition is taking place, or hear someone who does, you must be flexible in your response. It's a lot like Darwinian evolution: Adaptability remains the key to survival. This is just as true for investors as it is for iguanas.

Ignore the market's reality in favor of the long-term view, and you'll die with your conviction intact -- but likely little else.

Apprenticed Investor: Know Thyself

By Barry Ritholtz

Statistical evidence suggests a high probability that you underperformed the broader market last year, and most investors will likely underperform again this year. But it's not just retail investors. The pros are barely any better. In fact, four out of five investors will do worse than the S&P 500 this year.

The problem, it seems, is a design flaw.

Indeed, many classic investor errors -- overtrading, groupthink, panic selling, marrying positions (i.e., refusing to sell), chasing stocks, rationalizing, freezing up -- are mostly due to our genetic makeup. Humans have evolved to survive in a harsh, competitive landscape. To do well in the capital markets, on the other hand, requires a skill set that is very often the antithesis of those innate survival instincts.

Why is that? The problems lay primarily in our large mammalian brains. It is actually better at some things than you may realize, but (unfortunately) much worse at many others you are unaware of. Most people are unaware they even have these (for lack of a better word) "defects." The fact is, when it comes to investing, humans just ain't built for it.

Psychology Vs. Economics

In order to understand how humans invest requires more than the study of economics; one also needs to comprehend behavioral psychology. Combining both cognitive science and behavioral economics can yield powerful insights into the conduct of investors.

I recommend Cornell professor Thomas Gilovich's book How We Know What Isn't So to investors all the time. The professor's contribution to the investment community is his study of human reasoning errors. More specifically, Gilovich studies the inherent biases and faulty thinking endemic to all us humans. These faulty analyses are pretty much hard-wired into our species.

How do these defects manifest themselves? In all too many ways: Humans have a tendency to see order in randomness. We find patterns where none exist. While that trait might have helped a baby recognize its parents (thereby improving the odds for its survival), seeing patterns where none exist is counter-productive when it comes to investing.

We also selectively perceive data, hoping to find something that confirms our prior views. We ignore data that contradicts those prior views. We even reinterpret old evidence so it is more in sync with our perspective. Then, we only selectively remember those things that support our case. Last, we overuse Heuristics, which is defined as simple, efficient rules of thumb that have been proposed to explain how people make decisions, come to judgments and solve problems, typically when facing complex problems or incomplete information (call them mental short cuts). These short cuts often generate "systematic errors" or blind spots in our analytical reasoning.

And that's only a partial list of analytical imperfections you have inherited.

The good news: These defects can be overcome.

We can develop an awareness of these specific defects, and we can learn to employ strategies that attempt to overcome these inherent analytical shortcomings.

What Have You Learned in the Past 2 Seconds?

Let's place these defects into a historical framework within the context of the capital markets. My favorite illustration as to why humans simply aren't hard-wired to undertake risk/reward analysis in capital markets comes from Michael Mauboussin, Legg Mason Funds' chief investment strategist.

Mauboussin takes our evolutionary argument -- the mind is better suited for hunting and gathering than it is for understanding Bayesian analysis -- and places it into a chronological context. In an article titled What Have You Learned in the Past 2 Seconds?", he creates a timeline of human history scaled to equal one day.

He starts at the beginning: Homosapiens came into existence 2 million years ago. Next, Mitochondrial Eve, the common female ancestor among all living humans, lived less than 200,000 years ago. Last, he notes that modern finance theory, the framework to which investors are supposed to adhere, was formalized about 40 years ago. If all of human history were a day long, then investing is only about two seconds old. Is it any surprise that most humans do it so poorly? The vast majority of human history has been spent learning to survive, not analyze P/E ratios.

Learning to fight nature won't be easy. To outperform, you sometimes must go against the crowd, despite the appeal and seeming safety in numbers. You must be humble and willing to admit error; meaning you'll have to overcome your ego's predisposition to avoid embarrassment, so as to maintain status amongst your tribe (and thereby enhance survival probabilities).

Most investors are overconfident to a fault. Don't believe me? Consider the following anecdote: A man was terrified to fly, yet thought nothing of roaring down the street -- sans helmet, no less -- on his Harley. That reveals a high degree of confidence in his own skills vs. a highly trained pilot's. That's some risk-analysis engine you got there, bub.

That blind faith in our own abilities may have come in handy on mammoth hunts, but it is hardly beneficial when to comes to picking stocks. And that's before we even get to the "flight or fight" response. Our natural instinct during periods of volatility is to stop the pain, not to endure it with patience. The natural reactions to discomfort or threat -- coupled with a natural inability to be patient -- doesn't serve us well in the market. During market bottoms, most of the herd is selling. To buy during periods of intense selling means leaving the safety of the crowd, standing out, risking humiliation.

We simply were not designed for that.

Why Not Just Index?

This overconfidence leads to the optimistic yet misguided belief that most of us can beat the market. We must believe we can outperform the major indices. Otherwise, the rational thing to do would be to simply buy a major index and forget about it.

A few recent studies support those conclusions. One in USA Today found that most people are no good at investing, and another in The New York Times revealed that people have a poor grasp of basic economics.

Most investors -- the 80% who underperform -- would probably be better off going the index route. If you're still interested in trying to outperform -- despite all we discussed today -- then I admire your gumption. Over the coming months, we will share some tools to do just that.

Next week, we take a closer look at the competition. (Be afraid ... be very afraid.)

Apprenticed Investor: Prepare for Battle

By Barry Ritholtz

The purpose of "Apprenticed Investor" is to teach you to become better investors. Today's lesson is about having a healthy respect -- not fear, but respect -- for your opponents.

I am always surprised at how eager and confident new investors are, entering the fray with hardly any hesitation. The reason for this is fairly simple: Many investors have achieved some level of success in their chosen field. This is how they have amassed their investing capital, and their prior success breeds a healthy self-confidence.

Healthy, that is, in your chosen fields. In the capital markets, that self-confidence is dangerous, even reckless. People tend to forget that once they become investors, they have essentially started a brand-new career -- and started at the very bottom, too.

Transitioning from a newbie to an accomplished pro will present many challenges. The self-confidence that served you so well in your other endeavors can hurt you when trading. Just as 90% of people consider themselves above-average drivers, so too do many people believe they are above-average investors. For the majority of these folks, that belief can be naive -- and potentially self-destructive.

A question I ask people who want to become traders (or even pros who want to become fund managers) is this: Do you have the skill set, discipline, temperament, time horizon, strategy and capitalization to enter into the most competitive gladiator ring on planet Earth?

The market is a zero-sum game. You win, someone else loses, and vice versa. That's certainly true on individual trades, and it's nearly true on the market overall. The only thing that prevents all of investing from being a true zero-sum game is that, over time, the pie gets bigger. At least, it has in the U.S. for the past 100 years.

Competitive Juices Flowing

It's important to understand who your opponents are on the field of battle. Sports and war metaphors abound, because they are consistent with what you are going up against. Yes, you are up against Mr. Market, but your rivals are also other people buying and selling stocks. They, too, are looking to produce positive returns.

Charles Ellis, who oversees the $10 billion endowment fund at Yale University, once observed:

Watch a pro football game, and it's obvious the guys on the field are far faster, stronger and more willing to bear and inflict pain than you are. Surely you would say, 'I don't want to play against those guys!'

Well, 90% of stock market volume is done by institutions, and half of that is done by the world's 50 largest investment firms, deeply committed, vastly well prepared -- the smartest sons of bitches in the world working their tails off all day long. You know what? I don't want to play against those guys either.

That's a brutal and, in my opinion, absolutely spot-on observation. The institutions Ellis refers to are mutual funds, hedge funds, charitable trusts, insiders, program traders -- and all of their professional traders and portfolio managers.

Want to know how fast these guys are? In his recent book, Running Money, Andy Kessler recalls a story about the run-up to the first Gulf War. Then-U.S. Secretary of State James Baker had flown to Geneva to meet with Tariq Aziz, his counterpart from Iraq, to see if a peaceable solution could be worked out: "Baker stepped out of the meeting and said, 'Regrettably...' Before he finished his sentence, oil prices spiked 30% and stock markets sold off," Kessler writes.

That's what you are up against.

Despite this daunting opposition, too many individuals step onto the field of battle with the pros with too little preparation. To carry the sports metaphor further, they end up receiving season-ending injuries to their investment and retirement accounts.

I frequently review these sorts of accounts. What I see causing most of the losses is simply an inadequate skill set. Some of the foolishness I see from the alleged pros is as bad as what the market "dabblers" have done. In the coming weeks, we will look at several things you can do to avoid the most common injuries.

Lawyers, Docs & Money

Consider this: If you have anything more than the simplest of tax forms, what do you do? You pay a professional to do your taxes. If you are accused of a felony, you get the best lawyer you can. Need heart surgery? You go to the very best hospital you can afford.

I put financial management right up there as a profession with medicine, law and accounting. Yet many people never even hesitate to take their hard-earned money, open an account and start trading.

Worse still is how nonchalantly these accounts get treated. Do you ask your friends at cocktail parties what's the best way to crack open a chest cavity, or which rib spreader they like best? No, you find the best heart man you can, and let him try to save your life.

It should be the same in the market, but it's not. People have committed months -- if not years -- of hard-earned income to investments based on cocktail party chatter, chat board rumors or astrologers. That's not what you call extensive due diligence. Idle rumor mongering in an online chat room is not the equivalent of hardcore, in-depth research.

I'm not suggesting that you should throw up your hands in desperation and hand over your accounts to the so-called pros. Rather, I want you to understand exactly what's involved and what you are facing before you plunk down your hard earned do-re-mi. It isn't that you cannot do it yourself -- my point is you darn well better get up to speed before you start doing it yourself.

I'm sure that some people will disregard all of this as self-interested blather. After all, my firm profits by having people pay us a fee to manage their money. And for many people, that's the best route. They are self-aware and realize they lack the time, discipline or interest to do it themselves. If you are reading this, I assume you want to do it yourself. This advice is to help you understand that you best get up to speed.

Still, even the most cynical amongst us must admit the following: It is outrageous folly to imagine that, in just a few hours a week, you can best the world's sharpest, best-equipped, fastest traders.

This is the not-so-secret problem with the online trading business model, i.e., why E*Trade (ET:NYSE) and Ameritrade (AMTD:Nasdaq) are reportedly in merger talks. It's also why Schwab (SCH:NYSE) set up its "trusted investor advisory." They all know the dirty little secret of the business: All too many frequent online traders eventually grind their assets away. (It also explains why E*Trade has diversified into banking, mortgages and other financial services.)

The most skilled and talented amateur traders eventually go pro (i.e., direct access), while many of the rest hack up their capital, sandpapering away their accounts through poor risk management and over-trading.

Knowledge vs. Wisdom

Just because someone hands you a bat doesn't mean you can hit a home run off of Roger Clemens (yes, another sports metaphor). The explosion of Web-based market data may have given everyone similar tools, but it did not grant them an equal ability to use those tools. There is a huge difference between information and knowledge, and between fact and wisdom.

I believe that many people can compete on the Gladiatorial trading fields. It requires hard work, discipline, intelligence and a willingness to learn things that are counter-intuitive. In coming columns, I hope to show you many of the tools you will need to succeed on that field of battle.

Apprenticed Investor: Bite Your Tongue

By Barry Ritholtz

If you have ever said -- or even thought -- any of the following, you need to re-examine your investing philosophy.

1. 'I love this company.'

This is the statement that gets investors into more trouble than any other, and here's why: You are not buying a company -- you're buying stock in a company. There's a universe of difference between the two.

Warren Buffett of Berkshire Hathaway (BRK.A:NYSE) buys companies; Cisco Systems (CSCO:Nasdaq) CEO John Chambers buys companies. When Jack Welch was running General Electric (GE:NYSE) , he bought companies. Mere mortals such as you and I -- we only buy stock.

It is arrogance to imagine you are purchasing anything more than a one hundred millionth of an ownership stake (or less) in these firms. The action of that equity is much more important to you as an investor than your personal affections for the entire company.

Microsoft (MSFT:Nasdaq) is a good example of this -- in 2002, you could have paid as much as $35 (postsplit) or as little as $20 per share. It's still the same company, but at the recent price of $26, one buyer is up 30% while the other buyer is down more than 25%. Same company, different entry prices for purchasing the stock.

That's why pricing and timing are so important.

Loving a company will not make up for a bad buy. Unlike VCs and corporate chieftains, we don't get to buy business models.

2. 'I am a long-term investor.'

The most astute thought ever put to paper about this statement was the classic quip by John Maynard Keynes: "In the long run," Lord Keynes said, "we are all dead."

The long dirt-nap aside, being long term does not mean abandoning the responsibility to set reasonable sell triggers on both the upside and the downside. Long-term investors should still review their holdings monthly (if not weekly) for various sell signals.

It's important to listen to what a stock is telling you. The long run is not an excuse for riding profitable positions all the way back down to break-even or worse. I like to use a trailing stop for these types of holdings (i.e., Altria Group (MO:NYSE) or Exxon Mobil (XOM:NYSE) ) to prevent giving back all the hard-won gains.

Consider this: The employees of Lucent (LU:NYSE) and Enron had loaded their own 401(k)s with their respective companies' stock; they thought of themselves as good long-term investors.

3. 'I just heard on CNBC (or CNN or Bloomberg) that...'

This is the kiss of death. Every trading desk in the known universe has CNBC (and CNN or Bloomberg) on in the background. They have screamingly powerful computers and wicked-fast T3 lines. They do this all day, every day. Unless you are among the fastest of the fast, by the time something hits CNBC, it's all over but the crying.

The lower-risk/easy trade is over by the time an item hits the airwaves. The reason it's on TV in the first place is that initial move -- that's what catches the attention of the producers. By the time it hits the financial shows, the news is already "in the stock."

Savvy traders are known to short into any temporary, TV-induced pop.

My head trader is fond of an expression: "Last man in pays for beer." Chasing the latest hyped stock is a sure way to foot the bill for everyone else's drinks.

4. 'I don't want to pay capital gains taxes.'

I consider this to be the single dumbest thing ever said by any investor anywhere. Period.

I cringe each and every time I hear this shockingly ignorant statement. There is simply no worse reason to continue holding a position than to avoid taxes.

Once you've maxed out your tax-deferred accounts, your goal should be to pay all the capital gains taxes you possibly can; lots and lots of 'em.

I'm reminded of an incident from '96: A friend of a friend had a huge position in Iomega (IOM:NYSE) . They owned tens of thousands of shares at an average cost around $5. The stock had split repeatedly, 5 for 4, then 3 for 1, then 2 for 1. This individual was sitting on what was rapidly becoming an institutional-sized position.

I asked when they wanted to sell, and got the classic answer: "Do you know what sort of tax bill that would generate?"

At the time, the stock was skyrocketing. At $50, it went parabolic. I watched this entire move, swearing I would not butt into someone else's trade. Finally, the stock went vertical, with the third exhaustion gap -- a sign that the buying frenzy was peaking. My willpower gave out: I pleaded with them to convince the holder -- not even a client! -- to at least lock in partial profits. "If you're not going to dump all of it, then at least sell half -- for crying out loud, lock in something."

All to no avail.

It's a shame when someone makes a trade of a lifetime and then blows it because of greed. The cliche is true: Bulls make money, bears make money -- pigs get slaughtered.

5. 'I'm waiting for the stock to come back to break-even.'

If you bought a stock which is now underwater, there are likely legions of people waiting for the same break-even point to get out. That's what the technicians mean by "overhead resistance."

In fact, much of technical analysis is based upon the psychology of people waiting to get out of -- or into -- a stock at a previously missed price. When a stock dips and then rallies, those who missed the previous low price wait for another opportunity to buy it there. That why it's called "support," and it's why buyers seem to appear at the same price on a chart in a given stock.

The reverse is true of sellers. Cisco is having a tough time getting through $24; every time it dips, holders kick themselves for missing that sale opportunity.

"If it only goes back to X, I'll sell there" is practically a mantra. Once a stock "breaks out" through that resistance -- preferably on big volume -- the supply of stock is exhausted at that level, and it's clear sailing to the next resistance level.

For Sun Microsystems (SUNW:Nasdaq) that number is $5.50, for EMC (EMC:NYSE) it's $15.50, and for Microsoft it's $30. These levels are the reason why traders follow "breakouts" -- and why some stocks have such trouble returning to your break-even purchase price.

Denouement

These "words of wisdom" reflect poor decision-making on the part of investors. These fables and legends contribute to investment behaviors that can reduce gains or cause big losses. They do not contribute to a person's financial well-being.

In a forthcoming column we'll take a closer look at the other five top (or bottom) things you might say and do that ultimately undermine your investing success.

Apprenticed Investor: Don't Speak, Part 2

By Barry Ritholtz

Last week, we reviewed five of the top 10 things investors say and do that ultimately undermine their investing success. This week, we continue the process. (For part 1 of the story, click here.)

If you have ever said -- or even thought -- any of the following, you need to re-examine your investing philosophy:

6. 'This stock looks cheap down here.'

Any time you hear this tidbit, you can bet that either 1) the stock just got killed because of some awful news, or 2) it's in the midst of a long and relentless downtrend.

Don't confuse stock price with value. This was especially true in 2001 after all the prior splits. Sun Microsystems (SUNW:Nasdaq) is a perfect example. Monday's closing price of $3.89 may sound inexpensive, but don't forget the five splits between 1995 and 2000; back them out, and the stock is $124.48. Same $13.25 billion dollar cap, but it doesn't sound so cheap minus the splits.

Of course, some stocks do actually get cheap "down here." But it has nothing to do with the numerical price.

7. 'This fund did great last year.'

This is the flip side of "looks cheap down here." It comes up whenever someone is considering putting money into a mutual fund.

It is the investing kiss of death.

Studies have demonstrated that last year's hot fund is this year's loser. The prior year's performance is the single worst indicator of the next year's numbers.

Some funds did well because their niche was hot that year. It could be a region -- last year, it was energy, a few years before that, Russia. Sometimes a sector is the flavor of the month. Defense was recently the darling of the moment.

Funds that represent niches often outperform in some years and badly underperform in others, as the factors leading to their outperformance were aberrational and often unlikely to repeat. That's why chasing last year's news usually results in poor performance.

In September 2002, Bill Gross' Pimco Total Return bond fund passed the Vanguard S&P 500 fund to become the biggest fund in the world. That was an example of investors piling into a "hot" sector and nailing the top of the bond market; it was also a month away from the bottom for equities.

Avoiding funds that did great last year should not be confused with funds that did great "last decade." Good money managers consistently post good results, with low drawdowns and lowered volatility. These managers don't have the aberrational years when they are up and then down huge.

Funds such as these are good places to put your managed money.

8. 'I'm a bull.' (or 'I'm a bear.')

I never understood these dogmatic declarations; investing is not college -- you don't have to declare a major.

Hypothetical question: Your get into your car to run some errands. Are you a "green" or a "red"? Do you make up your mind and simply drive through the next red signal, just because you are a green? Do you come to a dead stop -- regardless of the color of the signal -- because you're a "red"?

It's a ridiculous question. You look at the color of the light and either step on the gas or the brake. The market is the same way -- when market sentiment, valuations and monetary policy are in your favor, you get long. When they are not, your portfolio should be more defensive.

9. 'I don't want to take a loss.'

A variation of "I'm waiting for the stock to come back to break-even," but with a new added factor: self-delusion.

Brace yourself for the bad news: You've already taken the loss. Just because you haven't yet sold, the position is irrelevant.

A key to successful investing is being honest with yourself. By saying they don't want to take a loss, investors are not admitting two things. First, that they made a mistake; they bought something and it went down. Fess up to it.

Secondly -- and this is even more important -- losses are a part of investing. The best stock-picker in the universe buys stocks that go down. That doesn't matter; what does is whether you recognize that reality and have a plan in place to deal with it.

10. 'I got a great stock tip.'

Stock tips are the last refuge of equity scoundrels. It's lazy, irresponsible and just plain foolish.

The plain truth is that the vast majority of "tips" are for horrific little stocks that don't have a snowball's chance in hell of ever amounting to anything -- at least not on a sustainable basis. In fact, many so-called tips are nothing more than the work of stock touts -- paid weasels whose sole job in life is to run up the price of some worthless piece of junk so unscrupulous sellers can exit at a desirable price. The "tip" investor is usually left holding the bag.

Ask yourself the following of all tipsters: What's their motivation? How good is their information? (If it's too good, well, then you shouldn't be using it anyway.) What is their track record?

I never trade on tips, but I have a network of other pros whom I regularly swap ideas with. This is very different than a "tip."

I deal with one trader who knows the gaming sector inside out -- that's his expertise. He's helped make his (and my own) clients a fortune. Another is an analyst (Charlie Wolf of Needham) who covers the PC sector -- he got me into Apple (AAPL:Nasdaq) at the bottom and out of Dell (DELL:Nasdaq) at the top. I sift through Cody Willard's telecom universe for ideas I like, and then run these through my own discipline.

I rely on far too many brilliant people to list them all. But I've tracked these sources for years, and I keep a log of every "tip" I get.

I missed lots of opportunities doing so, but avoided even more dogs. When Doug Kass tried to steer me away from AOL a few years ago at $52, I didn't know his track record well enough to heed his advice. That was 35 points ago; fortunately, I got stopped out for "only" a $3 loss. Had I known this person better, I might have heeded the advice.

But that's part of the game of investing...

Apprenticed Investor: The Zen of Trading

By Barry Ritholtz

So far the Apprenticed Investor series has discussed a lot of don'ts. Don't do this, don't do that; avoid talking to these kinds of traders; don't say or think these kinds of things.

Well, it's time to shift gears, and since trading is an active enterprise, I'll discuss some things you should do. I plan to expand on these ideas significantly in future episodes.

Taken together, the following 10 rules will not only help you with the philosophical grounding necessary for thoughtful -- and successful -- investing, they will help you avoid some of the more common mistakes made by investors and traders early in their careers.

This is the "Zen of Trading;" It is more than an overview -- it's an investment philosophy that can help you develop an investing framework of your own.

1. Have a Comprehensive Plan: Whether you are an investor or active trader, you must have a plan. Too many investors have no strategy at all -- they merely react to each twitch of the market on the fly. If you fail to plan, goes the saying, then you plan to fail.

Consider how Roger Clemens approaches a game. He studies his opponent, constructs his game plan and goes to work.

Investors should write up a business plan, as if they were asking a Venture Capitalist for start-up money; just because you are the angel investor doesn't mean you should skip the planning stages.

2. Expect to Be Wrong: We've discussed this previously, but it is such a key aspect of successful investing that it bears repeating. You will be wrong, you will be wrong often and, occasionally, you will be spectacularly wrong.

Michael Jordan has a fabulous perspective on the subject: "I've missed more than 9,000 shots in my career. I've lost almost 300 games. Twenty six times, I've been trusted to take the game-winning shot and missed. I've failed over and over and over again in my life. And that is why I succeed."

Jordan was the greatest ball player of all time, and not only because of his superb physical skills: He understood the nature and importance of failure, and placed it appropriately within a larger framework of the game.

The best investors have no ego tied up in a trade. Those who refuse to recognize the simple truism of "being wrong often" end up giving away unacceptable amounts of capital. Stubborn pride and lack of risk management allow egotists to stay in stocks down 30%, 40% or 50% -- or worse.

3. Predetermine Stops Before Opening Any Position: Sign a "prenuptial agreement" with every stock you participate in: When it hits some point you have determined before you purchased it, that's it, you're out, end of story. Once you have come to understand that you will be frequently wrong, it becomes much easier to use stop-losses and sell targets.

This is true regardless of your methodology: It may be below support or beneath a moving average, or perhaps you prefer a specific percentage amount. Some people use the prior month's low. But whatever your stop-loss method is, stick to it religiously. Why? The prenup means you are making the exit decision before you are in a trade -- while you are still neutral and objective.

4. Follow Discipline Religiously: The greatest rules in the world are worthless if you do not have the personal discipline to see them through. I can recall every single time I broke a trading rule of my own, and it invariably cost me money.

RealMoney's Chartman, Gary B. Smith, slavishly follows his discipline, and he notes that every time some hedge fund -- chock full of Nobel Laureates and Ivy League whiz kids -- blows up, the mea culpa is the same: If only we hadn't overrode the system.

In Jack Schwager's seminal book Market Wizards, the single most important theme repeated by each of the wizards was the importance of discipline.

5. Keep Your Emotion In Check: Emotion is the enemy of investors, and that's why you must have a methodology that relies on objective data points, and not gut instinct. The purpose of Rules 1, 2 and 3 is to eliminate the impact of the natural human response to stress -- fear and panic -- and to avoid the flip side of the coin -- greed.

Remember, we, as a species, were never "hard-wired" for the capital markets. Our instinctive "fight or flight response" did not evolve to deal with crossing moving averages or CEOs resigning or restated earnings.

This evolutionary emotional baggage is why we want to sell at the bottom and chase stocks at the top. The money-making trade -- buying when there's blood in the streets, and selling when everyone else is clamoring to buy -- goes against every instinct you have. It requires a detached objectivity simply not possible when trading on emotion.

6. Take Responsibility: Many folks believe "the game is fixed." To them, I say: get over it. Stop whining and take the proper responsibility for your trades, your losses and yourself.

Your knowledge of the game-rigging gives you an edge. So use your hard-won knowledge to make money.

We have a national culture of blame-passing, and it infected investing long ago. Enron did not cause your losses, and neither did stock-touting analysts, or talking heads on CNBC. You did, and the sooner you accept this, the better off you will be.

A Chinese proverb is particularly insightful as applied to trading: "He who blames others has a long way to go on his journey. He who blames himself is halfway there. He who blames no one has arrived."

7. Constantly Improve: Investing is so competitive that you cannot afford to stand still. Investors should constantly seek to raise their skill level by learning as much as possible about the markets, the economy, trading technologies and various schools of investing thought. But whatever you read, you must do so with a keenly skeptical eye, while retaining an open mind ('taint easy to do).

One way to constantly improve is to find something for which you have a peculiar natural proclivity for and develop that gift. It may be moving averages, or position sizing, or MACD, or Bollinger Bands or the Arms index. Perhaps you have an expertise in some aspect of technology, or a particular sector.

This is essential because a developed expertise yields ancillary benefits. It bleeds over into everything else, with net positive results. The specific area of expertise you own does not matter as much as having one. Those of you who have been trading for a while will know exactly what I am referring to.

8. Change Is Constant: Heraclitus was a Greek philosopher best known for his "Doctrine of Flux": "The only constant is change."

That doctrine is especially true in the markets. Therefore, as you constantly upgrade your skills, you must remain supple enough to adapt to an ever-changing field of play.

Human nature -- especially in herds -- is unchanging. But these behaviors must be contemplated within their larger context. Add a new element -- PCs, lower trading costs, the Internet, vast amounts of cheap data, even CNBC -- and you introduce a new factor that impacts all the players on the field.

As conditions change, you must decipher how they impact your strategy, your emotions and your trading -- and adjust accordingly.

9. Learn to Short/Hedge Stocks: Short is not a four-letter word. Successful traders learn to play both sides of the fence. That's less controversial today than it was as the market was first falling apart, but it is no less true.

When a particular strategy isn't working, the market is telling you something. Thoughtful traders must consider whether there are bigger issues than their own trading mechanics when they enter a losing streak.

In Law School, students learn they have to be ready to argue either side of a case. You never truly knew a case until you could argue both for and against it. Only when you were able to see its warts could you truly appreciate the beauty.

The trading corollary is that you should never own a stock unless you know what makes it an attractive short. Each buy and sell decision should be an argument pro and con.

The market is cyclical; count on a bear market every four years or so. Unless you plan on sitting out for 18 to 24 months once or twice each decade -- as much as four years out of 10 -- you better learn to either short stocks or hedge long positions.

10. Understand Sector Strength and Market Trend: This rule generates the most "pushback" of any on the list, because it's so counter-intuitive: Stock selection matters less than you think.

Studies have convincingly demonstrated that about 30% of a stock's progress is determined by the company itself; a stock's sector is equal to at least another 30% (if not more). The overall direction of the market is an even bigger factor, counting for some 40%.

If you own the best company in the wrong sector, or buy the greatest stock when the broader market is going the other way -- both positions are likely to be losers. But if you see a strong sector, the market trend will help out even the weakest stock in the bunch.

So that's the 10 rules I call the "Zen of Trading."

Investing skills are worthless without a broader framework in which to practice them. The above rules will provide you with that frame of reference. They were as true 100 years ago as they will be true 100 years from now. Those who develop a plan and an investment philosophy are on the path to achieving trading success.

Apprenticed Investor: The Folly of Forecasting

By Barry Ritholtz

As a chartered member of the chattering class, I am all too familiar with the "perils of predictions." Anyone who works in the financial field and speaks to the press eventually gets tagged for a market forecast gone awry. It's an occupational hazard.

Unfortunately, investors all too often give these "predictions" in print or on TV far more weight than they should. It's very easy for a confident-sounding analyst, fund manager or professor to say something on TV that can throw off the best laid plans of investors.

I wish an SEC-mandated disclosure accompanied all pundit forecasts: "The undersigned states that he has no idea what's going to happen in the future, and hereby declares that this prediction is merely a wildly unsupported speculation."

Don't hold your breath waiting for that to happen.

The bottom line is that I've yet to find anyone who can accurately and consistently forecast the market behavior with any degree of accuracy, beyond short-term trend following. That inconvenient factoid never seems to dissuade the prophets -- or the press -- from their fortune-telling ways.

There are a few things that investors should keep in mind when encountering these speculations. Whenever you find yourself reading (or watching) someone who tells you where a stock or the markets are going, consider these factors:

• No one truly knows what tomorrow will bring. Nobody. Any and all forecasts are, at best, educated guesses.

• All prognostications are instantly stale, subject to further revision. Conditions change, new data are released, events unfold. Yesterday's prediction can be undone by tomorrow's press release.

• In order to "become right," some investors will stand by their predictions despite a stock or the market going the opposite way, hoping to be proven correct. Ned Davis called this the curse of "being right rather than making money."

There are only two kinds of predictions that have some value to investors: One is probability-based, and the other is risk-based. As long as you apply the same rules -- no one knows the future, they are subject to revision and should not be taken as gospel -- then these are sometimes worth considering.

Probability assessments are typically based upon historical comparisons of prior markets with similar characteristics: The more variables that align, the higher the likelihood that a given scenario plays out in a similar fashion. They are of this variety: In the past, when X, Y and Z all happened together, then we expect that A is most likely, then B is possible, while C is the least likely.

That doesn't mean A will happen or C cannot -- only that there's a specific probability of these events occurring out of the millions of ways the future might unfold. Whether any particular scenario plays out is determined by how the countless variables interact over time.

Looking at the future in terms of various probabilities is a productive way to position assets and manage risk. Why? If your expectations for the future recognize that this is but one possible outcome, then you are more likely to consider and plan for other contingencies. It builds in an expectation that other scenarios can and will occur.

For example, one signal I use is to determine when to sell (the subject of a future column) is after a long uptrend is broken. It's not that stocks cannot go higher after breaking their trend line -- they sometimes do. However, most of the time this happens it signals a significant change in institutional behavior towards the stock. Typically, it reflects a shift from fund accumulation to distribution.

For those people who have been enjoying the ride in Google (GOOG:Nasdaq) -- especially the near vertical move since April -- this is a high probability strategy. Once that trend line gets broken, say adios muchachos, take your profits and move along.

Again, a trend break is not a guarantee that the upside is finished, but it's a fairly good probability assessment.

The second type of good prediction is the risk-based discussion. These forecasts care less about price targets -- instead, they are an assessment of danger. In other words, to buyers of stocks under the present conditions, when this, that and the other are happening, you are taking on more (or less risk) than is typical. Saying the markets contain more or less risk at given times is a very different statement than: "I think the Dow is going to go to X."

I engaged in a combination of broader market-based probability this week in Smart Money, along with future risk assessment. Given the change in character the market displayed since the April lows, I noted the high probability of a substantial rally in the second half of the year. My basis for this was part technical -- the market regaining its prior trading range -- and part anecdotal (all the hedge fund cash on the sidelines). This created a high probability of a move similar to what we saw over the summer of 2003.

But I also included a risk-based assessment based upon the age of this bull move, along with the decaying macroeconomic environment; in tandem, they set up an increasing risk environment as the year progresses. That's how a top can form, and that presents an increased risk of a market correction or even collapse.

When you stop to consider all of the unforeseen actions that might occur between now and then, however, it becomes pretty apparent that all forecasting is at best a low probability activity.

Chaos Theory

Why are the markets so difficult to predict? To borrow a phrase from the physicists, the market demonstrates "unstable aperiodic behavior in deterministic nonlinear dynamism."

This behavior is better known as Chaos Theory.

What does that mean in English? The market is called "aperiodic" because it never repeats itself precisely the same way. Weather is also aperiodic -- it may be colder in the winter than in the summer, so there is a degree of cyclicality. But the day-to-day changes are never exactly the same year after year. The same dynamic applies to the markets: There are similarities from one era to another, but it's never identical. In Mark Twain's words, "History doesn't repeat, but it rhymes."

The markets also act with a surprising degree of instability. Small forces can create disproportionately large reactions. A surprising economic report, an off-the-cuff comment by a Fed official, a small change in earnings by any one of 1,000 companies; any one of these data points can roil the market. That behavior does not occur in what the scientists call "stable" systems.

Given the complexity of both the capital markets and the physical universe, we shouldn't be that surprised that Chaos Theory is so applicable to the financial markets.

Considering how little we know about the totality of market conditions -- and how incredibly intricate and complex the system is -- it's no surprise that pundit predictions are so frequently poor.

Apprenticed Investor: Lose the News

By Barry Ritholtz

Have you ever noticed how the stock market reacts differently to the same reported events?

Why is it that we sometimes sell off "in response to rising oil prices," but at other times the "market rallied, despite the rise in the price of crude"?

How come a selloff was caused by a suicide bombing in Iraq, but a week later, the markets shrugged off an even larger, deadlier bombing? Is it possible that the markets are responding to forces other than the latest headlines?

Short answer: Absolutely. Yes.

Longer answer: Keep reading.

As we discussed last week, it's clear that predictions of pontificating pundits have an extremely short shelf life and can be safely ignored. But it's not just the talking heads who can throw you off your game. The value of the entire financial news complex -- both print and electronic -- seems to be hugely misunderstood by investors.

Even worse, many investors misapply what they hear; they ignore data, focusing instead on headlines and occasionally, the opinions. There are at least three problems with this approach:

• First, news is hardly new. The vast majority of it is backward-looking, informing you as to what has happened already. Investing is about what is going to happen; what's occurred in the past may be of interest, but it's hardly germane to the investment process. Indeed, by the time the news is "out," it already has been built into the stock price.

Worse yet, old news can have an impact on your thought process. That's why I read The Wall Street Journal on the train home, and not on the way to work. Why? It forces me to recognize that the news is stale, and I avoid allowing it to influence my decision-making process. Instead, it becomes for informational proposes only (Yes, I really do this).

• Second, the vast majority of news is irrelevant to your investing.

Sure, the data points on occasion may be important, but the rest is essentially infotainment and filler. I find CNBC both informative and entertaining -- but it's not the basis of my investment decisions. This explains why there aren't any hedge funds running money on the basis of what's on TV.

Even with situations that involve binary events -- a yes/no FDA decision, a litigation outcome, an earnings report -- it's not the news coverage of these that matters so much as the actual data point.

Did the FDA approve a new drug or not? The subsequent reporting is irrelevant; it's the event that matters.

Quite often, it's not the news that matters, but the reaction to the news. Look at Intel's (INTC:Nasdaq) midquarter update. It was good all around, but the stock has since slipped. That's because the improved environment, especially for laptops, was already well known. It was fully built into Intel shares.

When we consider events of even greater historical significance, we discover something rather astounding: Over the long haul, the markets ignore things like Pearl Harbor, JFK's assassination and even the Sept. 11 terrorist attacks. Gary B. Smith showed how after their initial response, the markets resume whatever their prior trend was.

• Third, because news organizations often try to appeal to as many people as possible, they have a disconcerting tendency to catch various trends just as they are peaking.

Have a look at these charts provided by Neal Frankle, author of Why Smart People Lose a Fortune. They offer a compelling explanation as to why the mainstream media should not be the source of your investment strategy; in fact, they can often be a strong contrary indicator.

|[pic] |

|Source: Why Smart People Lose A Fortune, by Neal Frankle |

|[pic] |

|Source: Why Smart People Lose A Fortune, by Neal Frankle |

|[pic] |

|Source: Why Smart People Lose A Fortune, by Neal Frankle |

|[pic] |

|Source: Why Smart People Lose A Fortune, by Neal Frankle |

Avoid the Headline of the Day

The news machine needs to create an enormous amount of content to have product to sell. Hours on TV and radio, pages in print and on the Web. Remember, most media are advertising-driven, and it requires all that content to be able to sell all those ads. (That's why jokers like me are on so often).

Just think about some of the recent headlines and their impact on both markets and individual stocks. The CEO of a major brokerage firm resigns -- who cares! Martha gets out of jail: Whoop-de-doo!

The media focus on the "sensationalistic or scandalous, rather than market-moving," observes Real trading diarist James "Rev Shark" DePorre. "Stuff like the firing of a CEO, the housing "bubble" or Martha Stewart's latest travails may be interesting, but they don't help you much with your investments."

I agree with Shark's contention that the "media are at their best when they focus on emerging market trends." You know, the stuff that has yet to make the magazine covers or major headlines. That may give you a push in the direction of an investable theme. Unfortunately, this sort of coverage is rare and often found in specialty magazines such as Wired, CFO and The Economist.

There are exceptions to every rule, and this one is no different. The most valuable thing the media can do for you is to grant you an audience with people you might not have access to otherwise.

It's particularly useful to see or read the wisdom from those people who do not need the publicity and have no agenda. They are merely identifying issues that they believe need to be addressed and that often are not.

This isn't to suggest that you should blindly follow the star investors: Simply because former (GE:NYSE) chairman Jack Welch or Berkshire Hathaway's (BRK.A:NYSE) Warren Buffett say something will happen is no guarantee it's going to come true. When others are opining about what's to come -- even the greats -- you should have a healthy skepticism.

Still, I will closely listen to any investment giant who has a spectacular track record over long periods of time, meaning his or her performance is not the result of mere chance.

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|[p|1. |Expect to Be Wrong |[p|2. |Your Fault, Reader |

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|[p|3. |The Wrong Crowd |[p|4. |Bull or Bear? Neither |

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|[p|5. |Know Thyself |[p|6. |Prepare for Battle |

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|[p|7. |Bite Your Tongue |[p|8. |Don't Speak, Part 2 |

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|[p|9. |The Zen of Trading |[p|10.|The Folly of Forecasting |

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|Check back for more of Barry Ritholtz's |

|Apprenticed Investor series |

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A few examples: T. Boone Pickens on Kudlow & Cramer a year ago saying oil's price rise was not a temporary phenomena; Julian Robertson on CNBC discussing the dollar; Former Federal Reserve Chairman Paul Volcker identifying structural imbalances in the U.S. economy in The Washington Post; and the Barron's interviews with folks like Ned Davis, Ray Dalio, Walter Deemer, Seth Glickenhaus and others.

Giving you access to such financial luminaries is one valuable service the media provide for investors. As for the rest, savvy investors know it's mainly just noise and entertainment.

Apprenticed Investor: Tracking Elephants

By Barry Ritholtz

Here's an interesting question: If you could look at one and only one source before buying your next stock, which would you choose: a fundamental analyst's report (with no charts in it), or the chart of your choosing? While I like having access to both, I cannot ever imagine buying something without first looking at the chart.

And so we wade into the ongoing battle between technical and fundamental analysts. Frankly, it's one of the sillier debates in investing. But I've heard so many bad arguments and misleading theories about technical analysis that I decided to weigh in.

Before we wade too deeply into the controversy, ask yourself: "Why do I need to choose?" Why wouldn't you use any tool that can be shown to have value? You wouldn't build a house using only a hammer, but no drills or saws. Why limit yourself away from a tool that can assist you as an investor?

I am not a pure technician. I use technicals -- but I also look at fundamentals, sentiment, monetary policy, cycles, trend, quantitative factors, and economic data. I employ every tool I believe can help my investment process, without making it overly complex or confusing. You should, too.

The Basic Theory

There is quite a lot of conjecture about how charts work, but they all boil down to this: The actions of everyone who has done their homework on a stock shows up in the chart.

Let's take the manager of a value fund. This person's methodology relies on fundamentals. He finds a stock he is interested in. His mutual fund has an enormous research budget and tools at its disposal. They put their staff to work, visit the company, speak to senior management, check the channels -- i.e. speak to vendors, suppliers, and customers -- to see how the company's product is selling. After they run through a long checklist, they decide to add the stock to the fund's portfolio.

You could do the same sort of research -- assuming you have the time and money. Or, you could see the result of this fund's work -- its decision to buy the stock -- in the chart.

Footprints of Elephants

You see, there's a crucial difference between a fund and an individual investor. When you make a buy decision, the odds are you pick up a position of a few thousand shares (at most). That's it! The stock either works for you or it doesn't.

Funds are different. They don't merely buy stock -- they build positions; huge, enormous, institutional-sized positions. Mutual funds receive constant inflows. They are always putting their money to work, on a regular basis over time. When most investors buy a stock, it's a single decision, a single point in time. The purchasing process by large funds occurs over a much longer period. Some positions can take months if not years to build -- or unwind. Note that the process works in reverse when firms are selling a stock.

The technical terms for the process of institutional buying is called "accumulation"; institutional selling is called "distribution."

Institutions account for 90% of the NYSE stock market volume -- and half of that is done by the world's 50-largest investment firms. These funds are like elephants -- huge, and secretive in nature. They don't want the world to know what they are buying, because they fear traders will front-run them. If you could buy a stock before they can, it would cause the funds to pay a higher price, thereby lowering performance.

But elephants leave tracks in the jungle. They may be secretive, but their enormous girth means that they can be tracked. The same is true for institutions.

Don't you think that knowing what these behemoths are up to can help you in the markets? If we know that once they buy a stock, they will keep buying it, isn't it a valuable piece of information to know what they are buying? Knowing what they are selling -- and will continue to sell over many months -- is even more important.

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That's the key to looking at charts: They are the footprints of elephants.

TA: The Basics

You do not need to become an expert technician to improve your investing. If you learn only a few basic things about charts, you will enhance your returns significantly.

Think of technicals as the "when" part of your strategy. Fundamentals are very good at telling you "what" to buy, but they are less proficient at telling you when to buy. The example we used previously was Microsoft (MSFT:Nasdaq) . In 2002, you could have paid as much as $35 (post-split) or as little as $20 per share; same company, different entry prices. The result is one investor with a 30% gain, while the other showing a 25% loss. Timing is the key to profitability.

Next week, we'll delve more deeply into many ways you can use technical analysis in your investing -- even if you rely (almost) exclusively on the fundamentals. Before then, I want to share the most important rule in all of TA: Do not buy a stock in a downtrend. You probably have heard this edict phrased differently: "Don't catch a falling knife." "Don't fight the tape." "Losers average down."

Regardless of the phrasing, it is the most basic tenet of TA. As mentioned above, institutional-size positions can take months or even years to unwind. A downtrend is nothing more than the footprints of that distribution in chart form.

If you learn nothing else about technical analysis, learn this lesson, which is visually represented by the accompanying chart of Ford (F:NYSE) .

|Auto Wreck |

|Ford's chart shows in grim detail why you must avoid buying stocks in a downtrend |

|[pic] |

Apprenticed Investor: Tracking Elephants, Part 2

In the last installment of the Apprenticed Investor series, we discussed how charts reveal the elephantine footprints of institutions and shared the golden rule of technical analysis: Don't buy stocks when they are in a downtrend.

But the charts have many other uses -- even for nontechnicians. Fundamentalists can use technicals to help with their risk management, as well as their decision-making process.

This can be accomplished without using complex pattern recognition to predict where a stock might go, or tracking volume for confirmation of a move.

Charts are far less squishy than fundamentals. They are not based on someone's estimate of what future earnings might be, nor do they require you to guesstimate management's skill set or presume the desirability of a new product.

My biggest complaint about Wall Street's fundamental analysts is their disconcerting tendency to downgrade stocks after all the bad news is out. Hey, once the problems are publicized, it's too late for the investor to avoid the bloodshed and tears.

One difference between technicians and fundamentalists is that we never listen to what management has to say: Never.

Quite bluntly, I'm too trusting of an individual and don't have the insight to know when a CEO or CFO is lying to me. So listening to their sales pitches offers me little in the way of trading advantages. And as we have seen over the years, the fundies who believe management often get caught with their pants down.

With that in mind, let's go over some of the less technical uses of technical analysis, focusing today on more defensive vs. offensive maneuvers:

Early Warning Signals

Savvy traders know that charts reveal a wealth of data, including early caution signs of potential underlying problems -- in real time.

To be more precise, charts reveal the behavior of those institutions that have already discerned a problem, long before the crowd has. Good chartists are out of the way before a disaster occurs -- or at least in the very early stages -- and not after.

Why? Because a chart that's rolling over reveals that better-informed, more-connected institutions with deeper fundamental knowledge than you or I have are selling.

There, I've said it ... it's out in the open now: Technicians free ride on the sweat of fundamental buy-side analysts.

The phrase "it's already in the price" means that people with superior knowledge have already bought or sold. It is the same thing with charts -- very often, it's in there.

Sell Signals

It's not just about avoiding disasters. Stocks give several loud and clear signals on charts when an uptrend is over. A new phase of sideways, range-bound trading may not be a debacle, but there are better places for you to put your money.

Breaking a long-term uptrend, as shown in the accompanying chart of Apple Computer (AAPL:Nasdaq) , falling below a significant moving average, or breaching key support, as evoked in the chart of General Motors (GM:NYSE) . These are all ways an equity reveals to you that it's time to head for the exits.

Why? It shows that fewer and fewer institutions are buying the stock. And as we have seen, this tends to take more than an afternoon to play out. That's why momentum strategies work -- at least for a while.

|Bruised Fruit |

|Apple's chart shows a clear break of its uptrend, a classic sell signal. |

|[pic] |

|Click here for larger image. |

|Source: Barry Ritholtz |

|No Brakes |

|Prior to its recent upturn, GM repeatedly failed to hold at important support|

|levels. |

|[pic] |

|Click here for larger image. |

|Source: Barry Ritholtz |

Risk/Reward Analysis

Charts help savvy traders determine what their possible upside is vs. their probable downside. Finding good risk-reward scenarios (i.e., up $4/down $1) means that even if you are wrong half of the time, you will still be making money.

This is accomplished by figuring out where the likely resistance is, and where likely support is. I avoid stocks where resistance is $1 away (reward) and support is $5 below (risk). For example, with support at $30 and resistance at $39, eBay (EBAY:Nasdaq) offers a good risk/reward as it approaches $32.

|Hitting the Bid |

|Technical analysis shows the spots where risk/reward favors eBay's stock. |

|[pic] |

|Click here for larger image. |

|Source: Barry Ritholtz |

Assume that you will hit .500. That means for every winner you pick, you also find a loser. This explains why you want the risk/reward ratio in your favor. I will buy a stock with a 3-to-1 risk/reward ratio -- potential to make $3 for a $1 of risk -- but 5-to-1 is ideal.

Relative Sector Strength

A company's performance is determined in large part by the sector it is in. (The health of the overall market is just as important.)

Sector charts clearly reveal whether an entire sector -- or the overall market -- is in an uptrend, a downtrend or merely going sideways.

Good advice: Even the best company in a sector trending downward has a tough time rallying.

I believe a bad stock in a good sector can go higher and do so more easily than a good stock in a bad sector. The PC business was awful after the Y2K upgrade. Even Dell (DELL:Nasdaq) got killed in 2000.

Consider also the online colleges in 2003. It wasn't just Corinthian Colleges (COCO:Nasdaq) -- they all screamed higher, even the lousy ones. That's sector strength at work.

Knowing this can help you decide whether to avoid a stock --or jump on board.

Charting History

A weekly three- or five-year chart gives you a broad historical overview of a stock or a sector. It provides an immediate snapshot of a firm's earnings history, both good and bad. Sure, you could read five years of 10-Ks and analyst reports, but why waste all that time? The picture is worth many thousands of words.

You can easily see how volatile a stock is with a quick glance. A chart showing wild intraday swings and sharp reversals might raise suitability issues for more conservative investors. A more measured, gradual chart might not fit the goals of short-term, more active traders. Either way, the chart provides some insight as to whether this stock is for you.

Reality Check

How often has a piece of fundamental data or a tidbit of "unknown" or hot information induced you to buy a stock? The chart lets you know whether that data point is baked "in the cake" already.

If someone tries to convince you to buy a stock because of the hot news he has, a quick glance tells you how warm or cool the news really is. A stock up significantly over the past three months implies that the hot tip you just got ain't so hot -- lukewarm is probably more like it. As my head trader is fond of saying, "Last man in pays for the beer."

Buying a stock based on an analysis that is not fresh or advantageous is a recipe for losing money.

Charts have more to offer than patterns and predictions. Savvy investors learn how to use them for recognizing warning signs, managing risk and selecting stocks. Over time, you will too

Apprenticed Investor: Nothing Doing

By Barry Ritholtz

Contributor

7/14/2005 10:22 AM EDT

URL:

Let's be blunt: There is something exhilarating, even thrilling, about trading. The adventure of putting a position on, the buzz of watching it rally -- it can be such a delight that it almost feels illicit.

Clearly there is a rush to trading, especially when the market is really hot. But if you are getting that excited by trading, then the odds are you have become far too emotionally involved in the trade.

This is a huge mistake.

Investing is serious business, with real dollars at stake. There are far cheaper, less dangerous ways to buy a thrill -- hang gliding comes to mind -- than trading and investing.

There's nothing wrong with having, say, 5% of your portfolio in a "mad money" account for more speculative trades or just to have "some skin in the game." But if you are trading to get your jollies, then you are not spending your money well.

So today, I'd like to talk about nothing; specifically, about doing nothing.

There are times when doing nothing is your best course of action. But knowing when to sit one out is a problem many investors have.

Become a Card Counter

A wiser man than me once observed, "Give me an edge, or I won't play."

In blackjack, professional gamblers keep track of the cards that have already been dealt. This gives them insight into the odds the remaining cards in the deck hold. That slight edge is enough for card counters to win regularly at the game -- and to eventually get banned from casinos.

Investors should play only when they can stack the deck in their favor. For example, I had terrific insight into Apple (AAPL:Nasdaq) very early, having gotten one of the demonstrator iPods in late 2002. It was so apparent to me this was going to be a monster hit that I had a huge leg up over those who hadn't been playing with the gadget. As I watched white ear buds sprout on my commuter train more and more, I knew it was a matter of time before the stock would react. That's a tradeable edge, which I took advantage of by getting long Apple before the rest of the world realized the impact of the iPod.

Same for Google (GOOG:Nasdaq) : I was a beta tester of the search engine early on, and it gave me insight into how vastly superior its search technology was long before the time of the IPO. The caveat is that once the entire world discovered Google, my edge disappeared.

Sometimes, we have an edge and don't even realize it. I am a huge Ray Charles fan, and I knew of Starbucks' (SBUX:Nasdaq) release of what was to be his final album, Genius Loves Company.

I should have realized that Starbucks was morphing from a coffee retailer into a "lifestyle purveyor." The company's music sales drew customers into the store. I should have suspected that the Aug. 31, 2004, release of the CD would positively impact the whole chain. That's a missed opportunity because I didn't even think about what turned out to be an edge.

As an investor, I want the deck stacked in my favor as often as possible. When I have little or no advantage, I'd simply rather not participate. That may mean avoiding specific situations or closing out a losing position. It also may mean knowing when to sit out a directionless, choppy market altogether.

The Lesson of Folding

At the panel discussion at the online expo in New York in January 2002, I actually overheard someone in the crowd say: "Stocks suck lately."

That's the equivalent of the poker player who says: "Man, that deck was cold for me tonight!" This player thinks it was the cards' fault. Guys like that helped pay for my undergraduate education.

When I'm playing poker, if I don't like the cards I'm dealt, I fold. It's that simple. Lose the ante, wait for the next shuffle. Unlike the professional baseball player, I don't have to face a wicked knuckleball pitcher. Likewise, you don't have to force a trade or an investment.

Unlike the poker player, investors don't have to even lose the ante. If you don't like the look of the table, you can say "deal me out."

Think about how people have been describing the investing environment in the past year: "What a tough, lousy market." If that's the case, then why play if you do not have to?

Focus on your decision-making process. Ask yourself these questions: How active should I be now? What sectors are working this quarter? What size lots should I buy now?

All too many investors are on autopilot; they always buy 1,000-share lots, they trade the same stocks, they make about the same number of trades per week. Why even trade if you don't like the market? That's a decision that too many people make without actually considering their options carefully. In short, they do the same things regardless of the conditions.

If you are not a card player, consider skiing: It requires constant adaptation to rapidly changing terrain conditions. If the mountain gets too icy, I like to sit in the lodge with the ski bunnies, drinking hot toddies. We have a phrase for those skiers who fail to recognize changing conditions and adapt to them: badly injured. So, too, can investors get badly injured by forcing the situation when they don't need to.

Participating in a given market or stock should be a conscious, well-thought-out choice. All too often, it appears to be one made on autopilot, and that is never good for anyone's returns.

I can trade from the long or short side, hedge with options, choose sectors, lot sizes, activity. In short, I can control the trade.

On occasion, I even choose to sit out a hand.

Try it sometime.

Apprenticed Investor: Surviving Silly Season

By Barry Ritholtz

Monday down. Tuesday up. Wednesday up, then down, then back up again -- big. Thursday, down over 0.5% for each of the major averages at midday.

Welcome to earnings season.

It may seem there is no rhyme or reason to how individual stocks respond to earnings reports. If you have been frustrated trying to make sense of it, you are in good company. Many traders have found gaming quarterly announcements to be a futile exercise. My own personal approach is that without some sort of an edge, I'd rather simply not play.

There are two keys to tracking earnings reports and the way a stock will trade afterward. The first is the expectations for the company's quarter. Not your expectations, rather the collective anticipation of analysts and fund managers for what the company will report and say during its conference call.

But playing the expectation game is only the first step. Once you determine how high the bar is set, you must then consider the stock's recent action. Some results are anticipated well in advance of the conference call. A quick look at a chart is often instructive.

We won't bother discussing a company like Kodak (EK:NYSE) , whose business has been eroding for a long time. The company simply missed its numbers. I'd rather look into why Citigroup (C:NYSE) disappointed. There are two explanations worth exploring; depending on which one you prefer, one makes these stocks a hold, the other a sell.

Some have blamed Citigroup's disappointment on the General Motors (GM:NYSE) blowup. If you believe that's the case, then Citi's problems are probably behind it, and you can hold it until October's report.

I suspect the explanation may be even simpler. Money-center banks like Citigroup have been the beneficiary of free profits, courtesy of the Federal Reserve, for the past few years. Why? The carry trade.

Ever since the Fed slashed rates to half-century lows, fixed-income players were able to borrow short (1%) and lend long. That was quite the gift from the Fed to the big banking and bond-trading firms. Not only were big houses making money on proprietary trading for themselves, but clients were doing the same -- generating significant commissions.

With the yield curve now nearly flat, the carry trade is pretty much done. This may be an example of where the massive government stimulus ended up masking otherwise mediocre performance.

As an agnostic trader, I think that, technically, Citi can be bought at around $44 with a very tight stop, and then again around $42, also with a very tight stop. But longer term -- especially after a (presumably) better third quarter, I am far less enthused about it. I'm not short the stock, but would consider doing so on any move back toward $53 after the third quarter is reported.

Tech Tightrope

Let's look at a few others: Why were IBM's (IBM:NYSE) , Apple's (AAPL:Nasdaq) and Intel's (INTC:Nasdaq) better-than-expected numbers greeted so differently?

IBM has been a serial disappointer, missing estimates something like five of the past seven quarters. So when the company actually beat Monday evening, very few were expecting it.

The chart below, however, suggests that someone had done their homework. While the stock traded flat from the May lows, it rallied smartly the two weeks before earnings. That suggests some very smart research -- or some very chatty execs (I don't know which).

|Big Blue Takes Off |

|IBM's pre-earnings rally could have been a tip-off to its strong report |

|[pic] |

|Source: Barry Ritholtz |

Yahoo! (YHOO:Nasdaq) was the polar opposite of IBM -- it is a "regularly beat-by-a-penny" outfit. When its earnings were in line with consensus, the reaction was dramatic. No one likes to pay a 50 P/E for a company that merely meets consensus.

|When Good Isn't Good Enough |

|Yahoo's valuation and pre-release rally left it vulnerable to a selloff |

|[pic] |

|Source: Barry Ritholtz |

Rational? No. Understandable? Completely.

Intel's report -- and subsequent stock action -- was similarly understandable. The robust sale of laptops, especially in Asia, has been a bright spot for Intel and the PC makers. But this was widely known. Perhaps Intel's midquarter conference call set investors' expectations too high.

|Flying Too High |

|Intel's midquarter guidance had raised expectations, setting the stock up for a fall |

|[pic] |

|Source: Barry Ritholtz |

Next, let's have a look at Apple. The expectations were that iMac sales would slow in anticipation of a transition to Intel chips. There was also plenty of chatter about iPod sales reaching saturation.

All wrong:

|Halo Effect in Action |

|Reports of iPod sales slowing left Apple primed to rally |

|[pic] |

|Source: Barry Ritholtz |

Then there's Hewlett-Packard (HPQ:NYSE) . The simple answer is that the good news was already baked in.

Consider that H-P's stock already had a nice run on the announcement that Mark Hurd was replacing Carly Fiorina as CEO. The expectation became built in that he would reorganize the firm, cut costs and slash jobs. The stock rallied on his appointment -- but yawned on the actual announcement. The share price reflected the reorganization long before it was officially announced.

|Pre-Baked Goodness |

|H-P's chart shows a classic 'sell the news' reaction to the restructuring |

|[pic] |

|Source: Barry Ritholtz |

Coming Up: Microsoft and Google

Microsoft (MSFT:Nasdaq) is another difficult stock for gaming earnings. The company is notoriously conservative in its guidance, actively seeking to lower expectations (the better to handily beat them).

But for the first time in quite a while, Mister Softee has a number of upcoming catalysts: XBox 2 before this Christmas; Longhorn OS should be out in 2006; and SQL Server 2000 and on-demand CRM (the better to compete with (CRM:NYSE) ) should be out shortly thereafter. And while Google (GOOG:Nasdaq) has an enormous lead in search, Microsoft's history is that it can slowly grind its way toward a competitive position in just about any space.

One caveat: The prospects of these future products represent the potential upside to Microsoft investors over the next few quarters. However, investors should remember that aside from their monopoly products -- Windows OS and Office -- most of its other product offerings --MSN, XBox, Hotmail, Spaces, etc. -- have not been big profit makers, and are all also-rans in terms of profitability for the world's largest software maker.

Still, the chart looks pretty darned good recently.

|Looking Good |

|Microsoft's earnings come as the stock has recently rallied, making it tough to game |

|[pic] |

|Source: Barry Ritholtz |

Google is a particularly challenging stock to game. The company is somewhat coy with Wall Street in that it provides no guidance. It's really just a guess as to whether it beats the whisper number (are there still whispers since Sarbanes-Oxley?).

But the reasons to own Google may not show up in a conference call. It has become, essentially, a brain trust with a legendarily difficult admission exam for new employees. Google is one of the most innovative companies on the planet, rolling out brilliant new product offerings on a regular basis. In many ways, it is the anti-Microsoft, with its best days ahead of it.

Heading into earnings, some shareholders may be tempted to take profits. Instead, I'd suggest shareholders with longer-term perspectives consider selling only part of their positions, or alternatively, hedge their long positions by marrying the stock to a put.

|Riding That Train |

|Google has been unstoppable, but the temptation to book profits is strong |

|[pic] |

|Source: Barry Ritholtz |

In Conclusion

Earnings reports often look like binary events -- do companies beat expectations or not? But the reality is more complex than that. The key to owning and trading stocks during quarterly reporting is the recent stock action, and the consensus expectations for the company.

Readers are cautioned, however, that without some insight into the company -- some special edge -- it is a particularly dangerous trading environment. Proceed at your own risk.

Apprenticed Investor: Curb Your Enthusiasm

By Barry Ritholtz

Want to become a better investor?

Get brain damage.

That's the finding of a rather unusual study by researchers from Carnegie Mellon University, the Stanford Graduate School of Business and the University of Iowa. It was published in Psychological Science in June, and its conclusions were reported in The Wall Street Journal last week.

But don't start playing football without a helmet just yet: It's not any type of brain damage that helped investors in the study, but rather, a very specific form: a site-specific lesion (a kind of tissue damage) in the region of the brain in charge of controlling emotions.

The investors who have these lesions are unable to experience fear or anxiety. It turns out that lacking the emotionality ordinary investors exhibit leads to better investment decisions. It is not at all surprising that the emotionally limited investors outperformed their peers. We know from experience that when investors allow their emotions to unduly influence them, they tend to make foolish -- and expensive -- decisions.

It was not simply a lack of emotions that caused the improvement in performance in the study. When presented with a high risk, higher return possibility, the participants with these site-specific lesions lacked the fear the other investors had. The more emotional participants failed to capitalize on these opportunities. In other words, they were greedy at the right time. That accounted for nearly all the difference in their performances.

But the basic lesson from the study is simple: Investors who learn how their emotions impact their investing -- and can get them under control -- stand to significantly improve their returns.

Emotions Undercut Performance

As discussed previously, human beings just weren't built for capital markets. We have numerous design flaws that work against us in the investment process. But once you become aware of how they impact your thinking, you have a chance at avoiding some of the more damaging behaviors. At the very least, you can try to work around some of these hard-wired foibles.

There are three broad categories in which emotions work against the investor: ego, flawed analyses and the derailed plan. Let's look at some examples within each category.

The ego issue may be subtler than you would expect; certainly, a prideful trader who is unable to admit he or she is wrong ends up holding losing positions longer than he or she should. That's an expensive flaw, and it's why investors who anticipate being wrong can more quickly -- and therefore less expensively -- cut losses.

But ego has an insidious impact on our analytical abilities as well. It is a subtle form of bias inherent in our thinking process. Ego is why we selectively perceive data, why we emphasize that which confirms our prior views. It helps us ignore new data that may contradict our preconceived notions. It even facilitates our forgetting information that is inapposite to our viewpoint.

That's a pretty powerful analytical flaw hardwired into our brains, damaged or not.

We have other analytical flaws that are emotionally related. Why do we over-emphasize the most recent data point in a series? Each new economic report generates a giddy excitement, almost as breathless as a child the night before Christmas. When we consider the volatility of these data series, and the hedonic adjustments each one must suffer through, it's apparent that they are of more limited individual value. Smart traders focus on the trend of these releases, and not any one data point.

And yet...

We might have enjoyed 10 good GDP reports in a row, but let one bad one slide out and we become fearful and nervous. Or consider the opposite: we've just had over two years of data suggesting that inflation is resurgent, yet the first monthly report (June 2005) showing CPI and PPI as flat caused the Greek chorus to sing that inflation has been defeated in our lifetime. That's hardly the case.

Then, there are fear and greed. These are the best-known market emotions, and they cause all sorts of problems for investors. Our passions have an unfortunate tendency of getting the better of us -- and at exactly the worst possible moment, too. It's not merely chasing hot stocks at the top or getting panicked out at the bottom that's so problematic: It's the impulsive destruction of our investment strategy and long-term plan.

Decisions vs. Decision Making

One of the reasons that emotionally restricted investors have an advantage over everyone else is that they eliminate emotional decisions. It's a battle between impulsive choices, vs. a process for making rational decisions.

Without the tug of adrenaline and dopamine, you can stick to your original investing plan. That's actually the key problem with biochemical or hormonal decision-making: It's not that the decisions are necessarily so bad -- although they often are -- but even more significant, they derail your original investment plan.

As investors, you need a plan that allows you to save an adequate amount of money for retirement. We'll delve into this further in a future column but, suffice to say, the biggest problem with fear and greed is that in the blink of an endorphin, they can derail a well-thought strategy.

Think of this in terms of food: Imagine you are on a carefully crafted diet. You eat only healthful meals from a list of ingredients that have a good balance of carbohydrates and protein, with a limited amount of fat. Now consider an impulsive snack. What are the odds that this cheat will fit into your planned diet?

That's the key problem with emotional decision-making. When carefully designed strategies are supplanted by an impulsive choice, you have a recipe for poor performance.

As Malcolm Gladwell's best-selling book Blink: The Power of Thinking Without Thinking makes clear, unless you are an expert with decades of experience, instantaneous reactions can often have disastrous consequences.

To be sure, the study has an inherent bias in it: The experiment was designed so "risk-taking was the most advantageous behavior." The less-fearful participants made higher return investment decisions. In reality, people have a tendency toward risk-averse economic decision-making.

That aside, there are important lessons to be learned:

• Do not allow your emotions to derail you from your plan;

• Learn when risk-taking is an appropriate course of action;

• It's not just the decisions, but the decision-making process that you can control.

Short of brain damage, there are ways to control the impact our emotions have on us as investors. Investors who do that achieve much better returns.

Apprenticed Investor: Six Keys to Stock Selection

By Barry Ritholtz

So far, Apprenticed Investor has dealt with a lot of theory. We've discussed how emotions lead to bad decision making, and why you should stick to your plan. But I know what you really want: some advice on how to select stocks. That's our goal today.

The idea is not to pick stocks for you, but to help you develop a methodology for selecting stocks -- a set of tools, a checklist of sorts, to help determine whether a given stock is worthy of your attention.

One caveat: We are not addressing whether you should be a buyer of stocks today. Our discussion assumes your asset allocation is appropriate, and that the market is not in a high-risk, low-return territory. I'll address each of those concerns in a future column.

So without further ado, here's our favorite prepurchase checklist.

How's the Chart?

Charts are a great time saver, and for that reason it's where we begin. You don't have to be a technician to uncover potential problem stocks quickly and eliminate them from contention.

Glimpsing at a chart provides three ways to erase a stock from your list: One, if it's been in a long downtrend, avoid it all costs; two, if it's been flatlining for years; and, three, if it's too volatile for your risk tolerance.

Note, however, that eliminating a given stock doesn't mean forgetting about it. Take, for example, the stock in a downtrend. Since we don't know when the institutional money (i.e., mutual funds) will be done selling, it's simply wiser to wait for them to finish distributing. You can use a 10-day moving average to let you know when the downtrend may be ending.

The same thinking applies to a flat-liner. Instead of guessing what's going to make it finally break out, apply the same moving average to let yourself know when the stock is finally moving.

Meanwhile, stick to charts that don't have problems. (For more detail on how to use technical analysis, check out "Tracking Elephants," parts one and two.)

How's the Sector?

Here's something few people are aware of: Academic studies show the sector a stock is in is actually more important to its performance than the company itself.

This suggests that even the best stock in a lousy sector will do poorly when that sector is out of favor. At the same time, any old company in a hot sector will do well.

For example, personal computers went nowhere after all of the Y2K upgrades were completed. Indeed, even Dell (DELL:Nasdaq) has been range-bound for the past three years. The same goes for the networking stocks -- what company is better than Cisco (CSCO:Nasdaq) ?

On the other hand, you could have thrown a dart at oil companies such as BP (BP:NYSE ADR) , ConocoPhillips (COP:NYSE) and Exxon Mobil (XOM:NYSE) or homebuilders, including Toll Brothers (TOL:NYSE) and Pulte (PHM:NYSE) , and they have been screamers in the past year.

Checking out the sector also gives you an idea of who the competitors are.

The same advice about individual charts also applies to sectors -- watch those sectors near the bottom of the performance rankings for signs of an impending turnaround.

Only buy stocks in good sectors.

What's Your Thesis?

Why buy this particular stock, in this sector, and why now?

That may sound like an obvious question, but it's often overlooked. You should have a specific reason to buy something, one that you can articulate in a sentence or two. It can be something fundamental, i.e., fiber to the premises. Have you found an overlooked value, do you have some insight into a new product, do you believe the new management can turn the ship around? All that is part of your investment thesis.

Part of your opinion should include a price target. Let's assume your hypothesis is right -- when the rest of the Street discovers the stock, where can it go? I prefer to use two targets: a reasonable price and a best-case scenario. That way, I can revisit my thesis later and see if a stock that's working is worth sticking with.

The investment thesis should also consider upcoming catalysts, which you should track to both confirm your upbeat view, and to see how the stock reacts.

Stop-Loss

The ideal time to determine a stop-loss is before you buy it -- while you are neutral, and have no emotional investment in the name.

Stop-losses come in many flavors: percentage, trend break, support, moving average. (We will discuss this topic in agonizing detail in the future.)

Your thesis may be your primary motivation for selecting this stock, but it's also a reason to jettison it down the road. When your thesis no longer applies to a given company, it's time to say "buh-bye." Let's say you bought Motorola (MOT:NYSE) because you so totally respect Ed Zander. If he resigns, guess what? Your purchase thesis has just become inoperative.

Your time horizon is another type of stop-loss. Not only should you determine how much you are willing to give up on any investment, but also how long you are willing to forgo other investments by locking up cash in this name.

Risk-Reward

This is another overlooked aspect of a stock selection. How much potential upside can you legitimately expect vs. your downside risk?

The reason this matters is that all stock-pickers are imperfect. Nobody should expect to be right every time. Indeed, if you are right half the time, consider yourself above average. That's why risk/reward is so important. The investor who bats .500 must not only offset his losses but also his commissions on all trades, and his taxes on the winners.

I find a 5-to-1 risk-reward ratio is ideal, meaning I can reasonably envision $5 of gains for every $1 of potential downside, but at a minimum, you want a 3-to-1 ratio. That way, even a .500 batter comes out ahead. Use your upside target and your stop-loss to calculate this ratio.

News and Earnings

Lastly, potential purchasers must familiarize themselves with all of the recent news on the stock, if for no other reason than to avoid an unpleasant surprise. Trust me, that's no fun.

Learn if there are any significant upcoming dates that could affect your holding. I've seen unaware investors buy stocks the day before earnings, only to have a weak report crush the stock price (ouch). Are there any upcoming court decisions, or a new-product introduction on the horizon? Pay particular attention to litigation, government investigations or regulatory agencies.

These items are not usually fatal, but they introduce another element into the mix. Indeed, sometimes it even creates opportunity. When Altria (MO:NYSE) (then known as Philip Morris) was in class action litigation, the stock became a teenager. If you understood the litigation, and were willing to accept the risk, there was a lot of upside.

Finally, if you want this checklist to be of any value, I suggest you actually track every stock you buy or are considering buying. Save them all in a binder and then input the results to a spreadsheet such as Excel.

The goal is to create a data source that allows you to eventually be able to see where you are going right -- and what you might be doing wrong. It's an invaluable tool.

P.S.

Notice that this list contains elements from the technical, fundamental and quantitative schools. When it comes to stock selection, I'm agnostic -- I use whatever tools contribute to the process. Just as you do not build a house with only a saw, there's no reason to ignore other tools, if they have value.

Apprenticed Investor: On Bended Knee, 8/25/2005 10:59 AM EDT

Let's assume you found a stock that meets all of your criteria and fits our checklist. Before you pull the trigger, we need to discuss your relationship with this stock.

That's right, whenever you buy an equity, you enter into a complex relationship -- with the stock, the company, its management, even your fellow shareholders.

Before your purchase, you are still in a flirtatious stage -- you have no history with the stock and therefore no baggage. That's the time -- before you get in too deep -- to lay out some ground rules governing this relationship.

What you need is a pre-nuptial agreement with the stock.

There are several reasons to create a document governing your affiliation with a stock.

The first is objectivity: Once you own something, you lose the ability to take a cold-hearted look. You've become invested in the company, literally and figuratively.

After you've (hopefully) invested serious time and energy before deciding to make a purchase, you become emotionally invested in the trade. Emotions are the flip side of objectivity, and they rush in to fill the void when objectivity is lacking. A stock isn't Old Yeller, but you would be surprised at how hard it is to make a clean break. (A prior column detailed the danger of emotions.)

By having a clearly defined set of parameters regarding how long you are going to hold the stock, and under what circumstances you will "file for divorce," you avoid making emotional decisions to either sell too soon or not at all.

The second reason is discipline, one of the keys to successful investing. All traders know that without discipline, even the best investment plan is worthless. In the classic investing book Market Wizards by Jack Schwager, the theme of discipline comes up repeatedly in interviews with traders of all sorts: commodities, stocks, currency, futures and fixed income.

Unfortunately, far too few investors actually have any. Indeed, whenever we hear of some hedge fund that blew up, you often hear a manager lament, "If only we had stuck to our discipline." The pre-nup is a way to ensure that you avoid that fate.

Third, and finally, you want a record (paper or computer) of what you were thinking before entering this investment. We're all too capable of rationalizing our actions after the fact. I've heard investors come up with every excuse in the world to hold a dying position rather than admit they were wrong and move on. The pre-nup helps to eliminate that counterproductive behavior.

The Terms

A good pre-nup should answer the simple question: What are grounds for divorce?

• Performance (bad): There are three objectives in jettisoning a poorly performing stock.

First, a recognition that you may have been wrong. For whatever reason, the trade simply didn't work. Perhaps it was the timing, or merely a case of bad luck. By having a strategy to cut your losses, you can redeploy capital more productively.

Second, avoiding the debacles -- the Enrons, Nortels (NT:NYSE) or Lucents (LU:NYSE) of the world that whither away to become single digits, or zeros. Avoiding these disasters with only minor losses goes a long way toward keeping your portfolio healthy.

Third, a disaster stock can easily dominate an investor's psyche. If you become totally wrapped up in a bad trade, it interferes with your ability to do anything else productive. Think back to how many people didn't even bother opening their statements during the 2001-2003 period. That's how debilitating major losses can be -- and why avoiding them is so crucial.

In the near future, we'll look into a few stop-loss strategies that will help you in preparing the pre-nup. The key is to have a written explanation of what will trigger a sell in advance.

• Performance (good): How long are you going to keep a stock that's making money? Under what circumstances will you take a profit? What if it becomes a huge winner -- at what point will you rebalance your portfolio?

While many people are concerned about what to do with a loser, they often forget that you need to plan for how to handle a winner. I employ a few strategies for dealing with this. First, I like to watch the uptrend -- if and when that's broken, that's certainly a good reason to sell some of the position.

Several successful traders I know use a simple 20-day moving average; when that cracks, they take profits. Another strategy is using the prior month's lows -- anytime a stock that's been moving higher breaks the previous month's lows, it's a sign that the trend may be over. This method can keep you in a strongly performing stock for several years.

Lastly, if a big winner gives back more than 25% of your gains, you may want to protect the rest of those profits by selling the stock.

Before you select one of these methods, play with them to see how they fit you style. Back-test these tactics to see how long they would have kept you in the few stocks that have been working this year -- the homebuilders, defense plays or integrated oils -- and where you would have gotten out of tech and Internet names from the 1990s. The key is finding a methodology that works for you.

• Original rationale: Once the underlying reason that prompted you to buy a stock goes away, sell the holding. Period.

For example, earlier this year I thought there was a good chance that Blockbuster (BBI:NYSE) was going to merge with Hollywood Entertainment. Carl Icahn had accumulated a large chunk of stock in both companies. A turnaround story, a billionaire investor and a merger meant there was potential upside for a name widely disliked by Wall Street. After a competitor, Movie Gallery (MOVI:Nasdaq) , won the bidding war for Hollywood Entertainment, it was apparent that plan was not coming to fruition.

With my original reason for owning the stock gone, I had no choice but to sell the stock for a small loss. A month later, bad news hit, sending Blockbuster down 30%.

This is a hard and fast rule of mine: Never hold anything once your original reason for ownership disappears. Whatever other reason you come up with is only an after-the-fact rationalization.

• Fundamental changes: When the fundamentals change for the worse -- and you've defined this in advance -- that's as a good a reason to sell as any. Unfortunately, by the time most investors realize that the fundies have changed, the stock is usually significantly lower. This is typically the worst reason to sell, timing-wise. But you can often avoid even more bloodshed by exiting the stock, especially if its entering a cyclical period of poor performance.

• Time: How long are you going to wait for this dog? You simply want an understanding -- in advance -- of the period of time you will be willing to wait for a stock to produce.

If a company is a slow grower with a good dividend, you might be willing to give it awhile -- even a few years. If it's a potential explosive grower awaiting a key catalyst, you might be less patient, giving it only a few quarters. Some trades may get a 90-day grace period, or less. But decide before you own it.

For Better or Worse

A marriage pre-nup is designed to protect your assets before the honeymoon begins. Experience suggests that once the dishes are being thrown, having an objective, unemotional discussion about who gets what is all but impossible.

The same thought process governs the stock pre-nup. It's designed to maximize your retention of assets in the likely event of an ugly equity break up. And it doesn't even need a lawyer!

Apprenticed Investor: Time Won't Wait, 9/19/2005 10:36 AM EDT

I love deadlines. I love the whooshing sound they make as they go by...

-- Douglas Adams

How much time do you have?

If you are like most people, the answer is probably "very little to spare." You spend most of your day earning a living. You then spend what little time remains trying to enjoy it with friends and family.

Now let me ask you a slightly different question: How much time do you spend planning for, and managing, your investments?

For too many people I've encountered over the years, the answer is "not nearly enough." Too many investors do not put a commensurate amount of time into keeping what's taken them so much time and energy to earn. Some studies have found people spend more time planning a week's vacation than they do their retirement.

It's somewhat ironic: The average American works longer hours than anyone else in the industrialized world. Yet we are lackadaisical in the amount of time we are willing to commit to handling those same dollars when they become investments.

This leads to all sorts of problems.

The good news is, however, it's a relatively easy problem to fix.

Investment Style Determines Time Requirements

Taking on a project the demands of which are beyond your abilities to meet is a guaranteed set of headaches. It leads to compromises, short cuts and losses. Yet some investors undertake a trading regimen that requires far more time than they have available.

The obvious example is daytrading. If you have a demanding job, trying to trade intraday -- while trying to juggle clients, subordinates and the boss -- is sheer folly.

Less obvious, however, are the investors who have longer time horizons -- holding positions for weeks or months -- on a few minutes a month. These are the position or swing traders, and the right amount of time required to do this, or at least do it well, is much longer than what many people have available.

As we mentioned previously, you are competing against some of the smartest and best-equipped traders in the world. They work 24/7 to uncover an edge. These are people who are at their trading turrets at 5:30 a.m., who work 12-hour days doing the same homework that you might be spending a few hours a week on.

If the guy on the other side of the trade -- the sell to your buy -- is spending far more time investigating a given company, sector or market, that stacks the odds against you.

A key question all investors must ask themselves is, "Does my investing style match my available time?"

If you find yourself somewhat harried when it comes to your investments, the likelihood is that you have too little time for your adopted style. Your options are simple: find more time or adapt a style more suited to your time available. For most people, that means shifting to an investing style that is less time-consuming.

Many find this adjustment to be uncomfortable. That is often because they are trading for the buzz, and not the long-term return. The solution to this is to turn 5% of your assets into your mad money (pun intended). Put them into a separate account at a different broker. Manage this for fun; manage the main account with a deadly serious purpose.

Matching Your Investing Style to Your Time

To determine how much time you should spend managing your own financial affairs, ask yourself the following questions:

• "How much time and energy do I have to follow the markets?

• "Can I do all the requisite research needed to dig up and follow companies?"

• "How committed am I to managing my own financial affairs?"

The answers to these questions may point you in the right direction when it comes to managing your financial affairs.

Investors sometimes forget that there is a spectrum of investor commitment: At one endpoint is someone who hires a professional to do it for them. At the other end of the spectrum is someone who spends every waking moment thinking about the market, looking for opportunities, doing massive amounts of research, watching every tick. You are most likely somewhere in between these two extremes. Matching your place on this spectrum to your time is the key to stress-free investing.

Even the investor who chooses the least time commitment strategy -- hiring a money manager -- often fails to realize the time this requires. First, you must find the appropriate person. Then, you need to ensure your investment goals are met.

I always suggest working through multiple personal references to find a money manager. Talk to several of their clients. Really understand their investing philosophy and risk management approach. If you hire someone, you will then need to explain to them your investing goals and risk tolerances in order to help them craft an investment strategy that meets your needs.

After all that is done, you need to manage your advisor as if he or she were a high-level employee. Make sure you read your monthly statement carefully. Are your investments consistent with the plan you first laid out?

This is the investment approach with the least time requirements, and yet many investors put too little time into even this. It requires at least an hour per month to review your statements and present holdings, a quarterly discussion to review the markets, and an annual meeting to update your plans.

|Got the Time? |

|Estimating time requirements for the most common investor styles. |

|Spectrum of Investors |Time Required |Success Depends |

|Buy & Hold |Minimal |Cycle driven (bull or bear mkt) |

|Hiring Money Manager |1 hour per month |Varies by mgr, plus quarterly updates and annual |

| | |reviews |

|Mutual Funds Holder |5 hours per month plus quarterly reviews |Market driven, plus mgr's skill level |

|Indices/Sector Funds |10 hours per month |Market driven, plus timing |

|Individual Stocks (long-term holders) |20 hours per month |On stock selection and trade management |

|Individual Stocks (med-term trading) |10 hours per week |On trade entries and exits, and position sizing |

|Short-term Trading |20-40 hours per week |Cash management |

|Source: Barry Ritholtz |

The table above shows my estimation of how much time is required for the most common investor styles. It includes finding investments and reviewing them on a regular basis. Note: The time involved is strictly for asset management. It does not include becoming a more educated investor, reading books, or financial publications such as this one. Nor does it include the time necessary to create your investment plan in the first place. It's simply my educated approximation as to the minimum amount of time required to make a given style work.

Adopting an investment strategy that requires more time than you can commit to is a surefire path to disappointment. Find a strategy and style that you can live with -- both intellectually and scheduling-wise. Make an "honest self assessment" of your resources.

This is one of the easiest mistakes in investing to make -- and to avoid.

Apprenticed Investor: Write This Down, 10/10/2005 7:34 AM EDT

"What was I thinking when I bought that pig?"

How many times have you asked yourself that question? Don't worry, you're not alone. It's an all-too-common lament among individual investors, whose portfolios are often littered with these losers. Almost as bad as the financial hit is the nagging related question, "How could I have ever been so stupid?"

Today, we address that issue. Included in our discussion are two basic tools that will help you look back and understand your own thought process, and the analytical steps you took -- or failed to take -- before buying that sow. More importantly, this process can help before you buy the next pig.

The Best Constantly Improve

Developing a way to both evaluate and improve your performance is one of the most important skills any investor can have. Yet far too few individuals have a mechanism by which they can review their stock picks, evaluate their trade management and assess their market calls.

This is a pity. Constantly reviewing your trading, recognizing what went wrong -- and right -- and adjusting your methods on the basis of what you learn is one of the simplest ways anyone can improve their skill set.

Reviewing strategy for weak spots and making incremental improvements is especially important for the Apprenticed Investor -- someone in the early stages of developing methodology. Indeed, fine-tuning your investing approach should be an ongoing process for all market participants. If you want your strategy to be competitive -- and have the returns to prove it -- you must constantly evaluate and refine your approach.

Today, we are going to outline a three-step approach:

• Serializing your pre-purchase thinking.

• Regularly reviewing your trades and existing holdings.

• Adapting what you learn to your strategy.

The Trading Diary

One of the best ways to evaluate your stock purchases, as well as their subsequent market performance, is to keep a trading diary.

The key idea is to do more than merely track your returns. Dozens of Web sites can do that for you, as does your monthly brokerage statement. Our goal is much more comprehensive. We want you to create a paper (pixel?) trail, memorializing your thought process prior to your purchases. More importantly, you need a way to evaluate -- after the trade -- what you could have done better.

Keeping a trading diary will help you accomplish these things: It will force you to maintain your pre-purchase checklist . It will also make you articulate why you made certain purchases. That often turns out to be important in the evaluation process later on, when trying to determine just why you bought that pig.

Having a clear idea of why you own a specific name will put you in a better position to see your entire investing picture. It gives you insight into your own performance. On an individual stock level, you may discover what tactical errors you may be making. Are you being too impatient? Are your stop losses too tight? Or are you letting stocks get too far away from you before you finally cut them loose? Technical traders might find that they are getting sucked into a false breakout; value investors might be buying cheap stocks that keep getting even cheaper.

The diary is also a good way to avoid repeating the same errors. I much prefer to discover new and different errors (and do so all the time!).

I don't mind the occasional error -- if I can learn something from it -- but I try never to repeat the same mistake twice.

Lastly, and perhaps most importantly, your trading diary will help you improve your overall strategic performance. Doing a post-mortem on your trades will help you adjust your strategy and philosophy. Are you over-trading? Are your positions too large? Perhaps you are bucking the major trend. Regardless, a good trading diary will help you understand exactly what you are doing right and wrong.

Words and Numbers

Let's get into the nitty-gritty of your trading diary.

There are two aspects to this. The first consists of documenting each individual position before purchase; this is simply another part of your pre-purchase research, and it will help you in your review process. The second aspect is analyzing your investing performance afterward, something we will get into in more detail in a later column. (For a preview, check out this link.)

The pre-purchase diary should be a simple one-pager; You should have down, in one place, all of the specific info you accumulated before making the purchase decision. More than mere info, however: These are the key data points you use to make your purchase decision. It can be on paper or in your computer; you can even blog it if you like. But the important thing is to go through the exercise of gathering all the data prior to making your actual purchase.

This attached Word doc is general, so it can be easily adapted to your own investing style. It includes elements of fundamentals (price-to-earnings, price-to-cash flow, catalysts, etc.); technical analysis (trend, volume, moving averages, etc.); and trade management (stop-loss, risk/reward ratio, holding period). If you do quantitative screening of any sort, this is also the place where you would describe the parameters.

Your trading diary is also the place where you write out what your "purchase thesis" is. It may be as simple as "This is an undervalued stock" or "I like the technical breakout." It could be "I think this new iPod thingie is going to be a big hit for Apple (AAPL:Nasdaq) ."

Lastly, I rank my potential trades on a scale of 1 to 10. I want to see if my own gut-level expectations for a position turn out to be accurate. Am I better off only buying 8s, 9s and the very rare 10s? Should I own a broader basket of stocks? The ranking process helps me understand my own analytical abilities.

You should play with the trading diary -- add to it, personalize it, make it your own. If anyone feels they have significantly improved on it, please send it in an email. I will share it with the readers in a next column.

Apprenticed Investor: Trading Diary, Part II, 10/20/2005 7:08 AM EDT

If you manage your own assets, knowing how well you did -- or didn't do -- is crucial to your success. To do this, you need a reliable method to measure yourself. Some of you may discover that it's cheaper, more tax-efficient, to simply index; you may ultimately generate better returns by avoiding stock selection and market-timing altogether.

But before you can make that decision, you need to know, in the immortal words of former NYC mayor Ed Koch, "How'm I doing?"

Last week we reviewed the importance of memorializing what you were thinking when you bought a stock. This week, let's figure out how well you are doing with what you purchased.

Like most people, you think you know what your performance is. But I'll bet you cannot tell me what your returns were for the past one-, five- and 10-year periods. How did you do last month and last quarter? How have you fared relative to the S&P 500, the Russell 2000 or the Dow?

If you cannot answer these questions, you know far less about your own performance than you thought you did.

The Mighty Spreadsheet

The basic tool to help answer these questions is the spreadsheet. We start with an Excel template, and today we will review several ways by which you can evaluate your returns. You will be able to compare how well you are doing relative to the benchmarks over any time period you like (daily, weekly, monthly, quarterly, etc.).

This Excel template is not locked; it's something you can -- and should -- customize to your own needs. (Special thanks goes to fund manager Dave Edwards for creating the original version of this for a column in 2000.)

The first thing you will notice is that the spread sheet contains many of the same topics we discussed last week in the trading diary. This is no coincidence, as these two tools are designed to complement each other.

By entering the information from the diary to the spreadsheet, you will be able to examine and review five separate components to your portfolio:

• Performance: Knowing how well you are doing -- on both a relative and absolute basis -- will help you determine if you need to make major or minor course corrections.

• Asset Allocation: You can very easily see when a position becomes too large relative to the rest of the portfolio. If most of the asset percentages are between 1% to 5%, that one stock or fund that's 14% really sticks out like a sore thumb. Recognizing this at least gives you the opportunity to decide if you want that much risk in a given stock.

It's easy to see when your portfolio is being dominated by a given sector. In the 1990s, it was tech and telecom; these days, it seems to be energy and housing that are slowly taking over portfolios. There's a reason you want balance, especially after an outsized move in an extended sector.

• Data Mining (Strategy review): Price-to-earnings, P/E-to-growth, market cap, growth rate, beta, dividend yield. These are just some of the criteria you can keep track of. This allows you to determine what criteria are working best, just at a glance. Are high P/E and big beta stocks doing well? Or are low P/E stocks with good dividend ratios what's working? Either way, that tells you something about your holdings -- and the overall market as well. It also shows you where some tactical adjustments might be necessary.

• Charts & Graphics: If a picture is worth a 1,000 words, then a spreadsheet must be worth a million: That's because you can take any and all of the entered data and turn it into a pie chart or graphic.

Let's do a quick experiment: look at columns L and M, and rows 35-44. It's the sector totals for both your portfolio and the S&P 500. Highlight column L, rows 35-44, then click on the chart wizard button -- it looks like a chart with a wand. Select a chart type (I like the pie chart), and then a sub type (my favorite is the 3D exploded chart). Click your way through the four steps. On the last one, select new sheet. Then click finish. Do the same thing for column M. The tabs at the bottom of the spreadsheet will let you switch back and forth between charts.

Look at your sector holdings breakdown, and then the relative weighting of sectors in the S&P 500. Are you comfortable with how similar or different your holdings are from the index?

• Record Keeping: Your spreadsheet becomes a backup to your regular statements. Trust me when I tell you, this is often a lifesaver in a pinch. Your purchase price, date of buy, quantity and commissions all have tax implications. Keeping a spreadsheet creates a powerful record-keeping system, including cost basis. When some crucial brokerage statement turns up missing around tax time, your accountant will be relieved you have a back up (he can thank me then).

Using a spreadsheet gives you the ability to see these items across your entire portfolio, and then to make whatever adjustments are necessary. You can "play with the numbers," to see how different alterations affect your overall holdings in real time.

The bottom line is that unless you know what the bottom line was, you cannot make adjustments. It's the key to good performance.

Caveats & Invites

Anything you do on a computer should be backed up, burned to CD or DVD, and stored in multiple locations (home, office, bank vault, lawyer, accountants, etc.). Excel files are small enough that you can email them to your Yahoo! or Google account monthly, and then save them. Again, you will thank me later for this.

Finally, I am making the same request/offer as last week: Play with the spreadsheet -- add to it, personalize it, make it your own. Anyone who feels they have significantly improved on it should email me an Excel copy. Fame and fortune await you; I may share truly outstanding improvements with your fellow readers in a subsequent column.

For instance, reader Perry Spector of Encinitas, Calif., made an astute observation regarding last week's column: Investors also need to keep a record of what and why a trade is passed over. That's a terrific suggestion. Knowing what you were thinking about the ones that got away can only help you with future stock selections.

Apprenticed Investor: Protect Your Backside, 10/28/2005 10:34 AM EDT

If you're going to manage your own investments, it is crucial to ensure that no one disaster results in utterly catastrophic losses. The goal is to protect yourself -- not only from outright frauds such as Enron, WorldCom, and Global Crossing -- but from the legitimate firms whose shares got shellacked.

Think about the plummet we saw in Amazon (AMZN:Nasdaq) , Yahoo (YHOO:Nasdaq) , EMC (EMC:NYSE) and Sun Microsystems (SUNW:Nasdaq) after the tech bubble burst; the full list is way too long to detail here.

In my opinion, managing risk and limiting losses are the most consequential -- and underappreciated -- aspect of investing. Loss limitation has a much greater impact on portfolio performance than either stock selection or market timing. How you manage the risk in your holdings will have a more profound bearing on financial success than your stock selection.

It's a shame the subject is not "sexy" enough to warrant greater attention in the financial media.

Capital Lost

Enron currently stands as the U.S.'s largest corporate bankruptcy in terms of lost value -- about $66 billion. But don't think it takes a combination of fraud, deregulation and complicity from the bean counters for disasters of this magnitude to strike equity holders.

In terms of lost investor wealth, Enron actually compares favorably to other flameouts. EMC, Cisco Systems (CSCO:Nasdaq) and General Electric (GE:NYSE) each "lost" over $100 billion in market cap from December 2000 to their 2002 lows. From the perspective of market-cap loss, Lucent (LU:NYSE) shareholders would also have been collectively better off owning Enron instead.

Even (once) mighty Microsoft (MSFT:Nasdaq) -- with a market capitalization of $266 billion as of Thursday's close -- has suffered enormous losses. From its split-adjust peak of $60, to its post-bubble low near $20, more than $300 billion in Microsoft shareholder valued has disappeared.

So compared with any of these market crash calamities, Enron loss is relatively minor. That is truly astounding.

And it's not just the tech sector where shareholder losses accrue: From December 2000 to the present day, pharmaceutical giant Merck (MRK:NYSE) has dropped $120 billion in value. Even oil colossus Exxon Mobil (XOM:NYSE) lost over $105 billion of market cap from November 2000 to July 2002, before rallying in conjunction with rising oil prices.

What Moves Stocks?

In order to limit the havoc "disaster stocks" can wreak, it helps to understand what moves share prices.

Investors typically look to a variety of short-term factors. Ask most people why their stocks are going up and down, and they'll reel off a list of news-driven events: economic releases, analyst rating changes, quarterly earnings reports, conference calls, etc.

These factors have a de minimus impact when compared to the real action. The true cause is much less complicated: Share prices are moved by large-scale buying and selling by institutions. We discussed this extensively in Tracking the Elephants.

This relates directly to Enron's stunning decline from over $90 to zero.

|Enron |

|From peak to pennies |

|[pic] |

|Click here for larger image. |

|Source: Barry Ritholtz |

Enron's stock gave many signals that it was under "distribution" by large shareholders. You may not have read about it in the paper, but Enron's chart told astute observers that big institutions were quietly unloading millions upon millions of shares.

A Fool & His Money

Using a modest stop-loss strategy, you could have bought Enron at its peak and limited your losses dramatically. Here's an example of how even an outrageous calamity like Enron need not be a total nightmare to a well-prepared investor:

Let's say someone was foolish enough to rely upon the sell-side analysts' "strong buys" on Enron in 2000. Our hypothetical investor -- let's call him Kenny Boy -- got suckered into Enron at the worst possible time, buying 1000 shares at its peak price of $90.

When he bought the stock, Kenny employed the very simplest loss limitation -- a straight 15% stop loss. He placed a "good till canceled" 15% stop loss order at $76.50. (Next week we'll go over a variety of stop-loss techniques.)

Towards the end of the year, Enron had broken $80 and was sliding further south. By mid-December 2000, the stock was flirting with Kenny Boy's stop point. Soon after, Kenny Boy was "stopped out" of Enron at $76.50.

Still, Kenny Boy's a sucker. He read a few positive articles on the company with titles like Enron's Power Play that got him excited again. As the broader market bottomed in April 2001, Enron appeared to stabilize. Just as Enron rallied to $60, poor Kenny Boy went back for more punishment. He bought another 1000 shares, with the same 15% stop in place.

A month later, the stop loss took Kenny Boy out again. This time, he was sold out of at $51, for a $9,000 loss.

Meanwhile, as the stock price slid, institutions may have been forced to dump shares in order to stay true to their investment style. For example, a large-cap growth fund, by its own charter, may not be allowed to hold mid-cap stocks. As a widely owned issue like Enron cratered, it created a self-fulfilling "death spiral."

As this was happening, our hypothetical investor remained a true glutton for punishment. During the post-9/11 swoon, Kenny Boy "caught the falling knife," once again picking up 1000 shares of Enron at $30. At least Kenny Boy was disciplined; he again relied on the 15% stop loss.

By the fourth quarter of 2001, stories were regularly appearing in the media about Enron's accounting issues. One day in October, after a particularly troublesome article, the stock "gapped down" at the open. Kenny's stop loss kicked in -- but not at $25.50 (15% below $30) as hoped for. Kenny Boy used a market -- as opposed to a limit -- stop-loss order. When the stock hit his number, his stop sell became a market order. The stock never traded at his number but "gapped down" to the lower price.

The gap down made poor Kenny Boy's execution awful; he was stopped out (for the third time), at $22.50 for a 25% loss.

Before we total Kenny Boy's losses, please note that he had the worst possible timing and execution possible. He bought at the top, got stopped out all three times, and even had a gap down which made his final sell much worse than expected.

Total damages: $30,000, or 33% of Kenny Boy's initial capital. That sounds pretty awful -- until you compare it with those people who did not have a stop loss plan in effect. These so-called long-term holders (also known as "deer in the headlights"), lost 99.89% of their capital. Their $90,000 initial purchase is now worth $110!

But unlucky Kenny Boy -- with a disciplined stop loss plan in effect -- still had $60,000 of capital left. The "buy and hold" crowd losses were 100% while Kenny Boy's were 30%. That's a huge difference.

Conclusion

Enron stands as important lesson in risk management and loss limitations. Jumbo losers can occur in any publicly traded company. Even "safe stocks" such as Exxon Mobil, GE and Microsoft are not exempt. Equities are volatile, and require a well thought out risk-management plan.

The key to avoiding catastrophic losses in any stock is in recognizing when institutions are dumping their shares and getting out of their way. As we have noted before, investors who fail to learn this lesson get trampled by elephants.

Apprenticed Investor: Stop-Loss Breakdown, 11/4/2005 3:04 PM EST

There's an old joke about the investor who never used any stop losses. His friend knew his big positions were getting crushed.

Out of concern, the friend asked, "How are you sleeping?"

"Like a baby" he answered.

"Really? You aren't nervous or upset?"

"I sleep like a baby" he repeated.

"That's amazing. I'd never be able to sleep through the night with those types of losses."

"Who said anything about sleeping through the night? I said I slept like a baby: I wake up every two hours, wet myself and cry for 30 minutes before falling back to sleep."

That's why risk management is so critical: to save you from sleeping like a baby, and in the long run to save you a lot of money.

Last week's column focused on protecting your assets and avoiding "fiasco" stocks. The method we discussed was the simplest of all stop losses: the percentage stop.

The percentage stop is not my favorite type of stop loss, but it is better than none at all.

The tricky part is deciding what percentage to use. Make the stop too tight (i.e., 6% to 8%), and in a volatile market you will get stopped out constantly. If the stop loss is too broad (i.e., 25%), then by the time it gets triggered, a lot of damage is already done.

I prefer percentage stops between 12% and 15%; longer-term holders and volatile tech stocks may need a little more room to oscillate. Your goal is to protect yourself against a position that's gone sour -- not against ordinary short-term market swings.

This week, we review several other stop-loss strategies you can use to prevent losses from getting out of hand.

All Kinds of Stops

• Stops Below an Uptrend: Placing a stop just below an uptrend is a technically based loss limit. The goal is to liquidate a position that is in the early stages of institutional distribution (i.e., mutual fund selling).

Use a daily or weekly chart, draw a line connecting the three most recent lows. On the far right side of the chart, place a mark a short way below that line. That's your stop loss.

|Don't Fight the Trend |

|When Cisco broke its long uptrend in mid-2000, it was time to bail on John Chambers & Co. |

|[pic] |

|Source: Barry Ritholtz |

This stop should be monitored as the stock price rises. Review it at least once a month; active traders review their stops more often, typically weekly (or even daily).

I know traders who like to re-enter a position after getting stopped out if it reverses back above the trend line. For example, when Apple's (AAPL:Nasdaq) trendline broke at $38, it looked as though the institutional world was in the early stages of major distribution in Apple. Once the stock returned to that trendline, we knew that was not true. It's worth occasionally missing a few points to avoid riding a profitable position back down to break-even or worse.

|Bruised, Not Rotten |

|Apple's trend break last spring was a false signal |

|[pic] |

|Source: Barry Ritholtz |

• Stop Loss Below Support: You don't have to be a technician to see where support is on a chart. Look for the horizontal line that a stock often trades down to, then bounces off. That line reflects the price where buyers find the stock compellingly cheap. It's also where they have reliably bought it in the past. Support often holds, because investors remember the last time that stock was that cheap and they failed to buy. That memory of missed opportunity is what supports the stock from falling further; your stop loss goes a little below that level.

|Retailer on Sale |

|Wal-Mart's break of long-term support was a sell signal |

|[pic] |

|Source: Barry Ritholtz |

When a stock breaks support, it suggests that the thinking about the company may have changed. Perhaps the company's prospects are no longer so rosy and the stock no longer looks cheap at that price.

Whatever the reason, a break in support often precedes a further move south.

On the other hand, buying a stock right above support, with a stop just below, offers good risk/reward potential. Downside is limited to a few points, while upside may be substantial.

• Stop Below Moving Average: One of the most reliable sell signals is the 50- or 200-day moving average (MA). The MA is the average daily closing price of a stock for a specific number of days.

When a stock is rising, its moving average will rise, albeit at a lag. Once the stock begins to falter, its price will fall much faster than the moving average. When the share price crosses the average to the downside, that's a very powerful sell signal.

Since the market peaked in March 2000, every major disaster -- from Lucent (LU:NYSE) to Global Crossing to WorldCom -- has given clear 200-day moving average sell signals.

• Trailing Stops: Any of the above stop losses can be turned into a "trailing stop." This strategy locks in specific profits and prevents you from giving back too much of a winning position.

Regardless of what your original stop loss was, you should raise it as a position rises. Each time your stock enters a new "decade" ($30s, $40s, $50s, $60s, etc.), you increase your stop loss proportionately. You can adjust the stop loss on the basis of the weekly or even monthly closing prices. This makes it more likely you'll get the benefit of a rising stock price for as long as possible, while still getting downside protection.

When moving your stops up, it's a good idea to avoid using round numbers (i.e., $60, $70, $80), because option strike prices can temporarily "pin" a stock to those levels on expiration day each month. There's a tendency for stocks to trade to just below these levels and then snap back. For lower-priced stocks (say, under $20), try using weekly increments of $5 instead of "decades."

• Profit Protection Stop Loss: One frustrating issue for investors is when a winning position starts reversing on them. Those profits that took so long to accumulate slowly start slipping away.

How can you avoid giving back all of your hard-won gains? I use the 25% net gains rule. Let's say you owned (AMZN:Nasdaq) in 2003, near $20. By the end of the year, the stock was above $60, giving you a 40-point gain. How do you preserve your profits if the stock reverses? Determine in advance how much of those profits you are willing to give back. I never like returning more than 25% to the house. When the stock reverses enough so that 25% of those gains have slipped away, that's your sell signal. In the Amazon example, that was a 10-point move down to $51. That's my liquidation point.

The goal of this stop loss is simple: Give the stock enough room to trade, but do not give back all of your profits.

• Time Stop: Stocks not only go up and down, they also can just go sideways. While this is not a dollar loss, it is a loss of a different kind. Tying up capital in a stock that's doing nothing involves opportunity costs. It means that your capital is not in another investment making money for you.

If you buy a stock at $17, and all it does is fluctuate between $15 and $20 for the next 10 years, there's probably a better place to deploy your capital. You can always come back to the name and buy in when it finally breaks out over $20.

When you purchase a security, decide in advance how long you are willing to hold it. Give it enough time for catalysts to develop. Six months to a year should be sufficient. The market is far less efficient than many people -- especially academics -- assume. If your stock is really undervalued, the rest of the world will eventually figure it out.

What you don't want to do is sell something out of boredom. Too often, this seems to happen just before a stock takes off.

In Conclusion

There's a reason flight attendants show you where the emergency exits are before takeoff. The same thinking should apply to investors. Prudent investors have a sell strategy in place before they get involved with a stock. Using any of these stop strategies helps keep your emotions out of the process when an investing emergency arises.

Barry Ritholtz

Apprenticed Investor: There Are No Shortcuts

11/16/2005 7:30 AM EST

Learn the Magic Formula!

Become a Stock Market Genius!

Get Inside the Millionaire Mind!

Become a One Minute Millionaire!

That's the message of several new books that, for lack of a better phrase, purport to have discovered the magic formula for investing.

Umm, I don't think so.

Sorry to be such a party pooper, but there is, of course, no such elixir. It takes some smarts, lots of hard work and a little bit of luck to be a successful investor.

But you probably knew that already, didn't you? If you have been following the Apprenticed Investor series, you know that we believe there is no such magic bullet. Successful investing requires effort and intelligence. We know it needs an ongoing self-evaluation process, one that requires constant adaptation and improvement. It demands a well-thought-out plan that is meticulously executed, with good record-keeping and data-mining.

The best investors aren't looking for a big miracle. Instead, they seek small ways to improve their performance, such as a capital preservation strategy that ensures minor losses do not become portfolio-wreckers. To outperform the markets requires attention to hundreds of small details such as knowing when to be a more aggressive and when to throttle back; when to do nothing; using risk management.

The best investors know their own weaknesses, and know how to keep their emotions in check.

Lastly, it never hurts to have the fair winds of chance blow your way. But magic formula? If it were that easy, then everyone would be rich.

Beat the Market

It seems that every year, a whole new crop of books comes out to advise you how to beat the markets. Over the years, there have been too many investment-advice books published to even mention. There's a related group of books that care less about stocks and more about saving money. A recent batch has titles like Secrets of the Millionaire Mind, The Automatic Millionaire and Cracking the Millionaire Code.

These collections tend to be filled with folksy advice on how to save a few shekels here and there. They range from the practical to the absurd: Buy used cars, bring lunches to work, and use a barber college to save on haircutting expense.

As The New York Times noted: "It is no accident that the authors of many of these books come from the stage of motivational seminars and late-night infomercials."

But it's hardly the stuff that makes for great investing.

To be fair, some investing books are worth exploring and considering on their own merits. Take, for example, The Little Book That Beats the Market, which has gotten some favorable press of late.

I have no problem with the book's main plan: "Invest in good companies when they are cheap." That's certainly one way to pick stocks, and it sure has worked for Warren Buffett. Of course, you also can use a technical method of stock selection. Or you can screen with quantitative data. Or you can rely on fundamentals to make your stock selections.

It really doesn't matter how stocks enter your portfolio. As we have shown time and again, stock selection is not where investors run into trouble. Managing the positions after they become part of the portfolio is where people typically discover their investing shortcomings. And that's before we get to a wealth of other important issues, including how and when to make purchases, how much of a given stock to buy (position-sizing), when to add to existing holdings, how to handle bad markets, when to use leverage, how to use options, how to hedge, when to use stop-losses, etc.

Here's a challenge I make to you, or Joel Greenblatt, the author of The Little Book That Beats the Market: You pick your best stocks, the ones you have done all the research on and know inside and out. Then give me a portfolio of randomly selected names.

I bet that over the course of a year, I can outperform most people's favorites by 20% by using only techniques discussed in the Apprenticed Investor series, such as stop-losses, money management, position-sizing, etc.

The point of this exercise is to demonstrate that stock selection is far less important to performance than a host of other factors. The overemphasis on stock-picking permeates the financial media. It's easy to see why. It has a good story line, an inherent dramatic conflict. It lends itself to the horse-race-type coverage that's so easily done. Plus, it's easy for readers to comprehend: Buy this, don't buy that. You can understand why the media and investors overemphasize it.

But the fact remains that regardless of the importance put on stock selection, most investors have underperformed the market, despite, I may add, recently going through the greatest bull market in history. That should raise serious questions to those whose sole emphasis is stock selection.

Consider how many fantastic stocks people owned in the late 1990s: Cisco (CSCO:Nasdaq) , EMC (EMC:NYSE) , Dell (DELL:Nasdaq) , Yahoo! (YHOO:Nasdaq) , (AMZN:Nasdaq) , Intel (INTC:Nasdaq) , Microsoft (MSFT:Nasdaq) , Qualcomm (QCOM:Nasdaq) , Juniper (JNPR:Nasdaq) , AOL, Iomega (IOM:NYSE) -- the list goes on and on.

Yet despite these marvelous stock selections, many people, probably most, did not do all that well. I would even hazard to guess that many holders of these terrific stocks ultimately lost money on them.

Where's your stock selection, now?

Better Investing Through Reading

Next week, we will discuss several investment-related books you should be reading. I will put together what amounts to a full course offering. It should take you several years of study to complete.

That's right, years. While some people would like to convince you that they have uncovered a shortcut, the overwhelming evidence -- painstakingly acquired through decades of investing and trading -- is this: Forget the magic formulas and the "get rich quick" come-ons: Investing is hard work.

If the market teaches us anything, it is that there is no free lunch. You don't get something for nothing. Be wary of any book that suggests otherwise.

Apprenticed Investor: Reading Is Fundamental

12/6/2005 7:32 AM EST

Investing is such a competitive arena that no matter how good you think you are, it is important that you constantly develop new skills and improve your knowledge base. You cannot afford to simply stand still.

How can you do this? By learning as much as possible about how the markets operate, what makes the economy work, about new trading concepts and various schools of investing thought.

Don't think of this as light reading. While digesting any investing-related material, you must do so actively, with a keenly skeptical eye. At the same time, you need to have an open mind. Doing both at once ain't easy.

As part of my ongoing education regimen, I try to read 10 to 20 market/economic/trading-related books per year. This is on top of my regular research and media diet. If out of that list, I find three books that are truly worthwhile, it's been a good year (this year was excellent). After 15 years of this, I've found quite a few books that are truly terrific, and should be of interest to any investor thirsty to learn.

Think of what follows as a course offering for those who want to improve their knowledge and skills. These were chosen for their readability, their wisdom, and their timelessness.

If this were graduate school, you would cover this reading in a year or two. But since you probably have a day job, family and other obligations, I suggest reading a book per month. Take notes -- I jot down extensive notes in the margins -- then a year later, go back and reread your annotations.

This is by no means a complete reading list. Many books were left off -- some were simply too advanced, others obscure, rather inaccessible. And that's not counting the pile of books I have queued up and haven't yet read. In order to keep any bias out of the list, I purposefully excluded books written by my colleagues at . The writers here have a broad body of excellent work -- and none of it is included. So don't take this list as the absolute gospel.

With that in mind, here is part one of my planned two-part introductory course in markets and investing -- perfect for the Apprenticed Investor:

Introduction to Investing

Any one of these books will give you insight into investing and the markets. All three will make an essential base for future studies:

• Market Wizards: Interviews with Top Traders by Jack D. Schwager

Schwager interviewed market legends at the height of their success. What makes the book so worthwhile are the consistent themes that evolve from currency traders, mutual fund managers, commodities traders, hedge fund managers. Regardless of what is being traded, there are related motifs that run throughout.

What results is not a "How to trade" book; instead, it is a book about "How to think about trading."

This has become a seminal book on trading and investing. I actually re-read Market Wizards every five years -- it is that good. Wizards was so well received by the financial community that the same author put out The New Market Wizards. Whether you read one or both of these books, you will have knowledge of the market from both the trader's and the investor's perspectives.

• The Investor's Anthology: Original Ideas from the Industry's Greatest Minds by Charles D. Ellis

Instead of interviewing famed investors, Ellis gathered their best writings into one collection. He ends up with a series of short chapters by luminaries of days gone by. There is something worthwhile on just about every page. This is another favorite worth rereading every few years.

• Bull!: A History of the Boom, 1982-1999: What drove the Breakneck Market -- and What Every Investor Needs to Know About Financial Cycles by Maggie Mahar

The best book about the past 20 years of the market, bar none. Mahar does a terrific job weaving the long tale of how things eventually reached their penultimate top in 2000. She spares no one -- the government, the Fed, Wall Street, her colleagues in the financial press -- all are subject to a scathing critique for their complicity in inflating the bubble.

Bull! reads like a historical work, despite the recentness of its subject. There are a surprising number of lessons buried in these pages that will reward the careful reader. I found it both fascinating and informative.

Historical Perspectives

It's astounding how little things have changed over the past century. Yes, information moves more quickly, and computing power has allowed for a more quantitative analysis of stocks -- but human nature remains immutable.

• How I Trade and Invest in Stocks and Bonds by Richard Wycoff

Quite simply, this is one of my favorite books on the markets and investing. The fact that it is from 1923 is totally irrelevant. If I could reprint the book with each mention of "coal" replaced with "oil," and if I substituted "Internet" for any time the word "railroads" appeared, you would have no idea when this was written. Indeed, you would think it was a current work.

There is probably more market intelligence and trading wisdom in this book per word than any other I have ever read. I strongly recommend this one.

• Reminiscences of a Stock Operator by Edwin Lefevre

By now, you have probably heard the story of Jesse Livermore. If you have ever said, "The trend is your friend" or "Let your winners run and cut your losses quickly," then you were quoting Livermore -- even if you didn't know it.

This is an absolutely exhilarating read. In fact, it is so much fun, it shouldn't count as homework or research.

Coincidentally, this was also published in 1923 -- apparently a good year for market-related books.

Psychology

As a species, we are notoriously bad at understanding our own thinking and emotions. We are even worse at predicting our own behavior. Understanding your own mind and those of your fellow investors is crucial to successful investing. These books will go a long way to helping you understand your hardwired weaknesses and blind spots.

• How We Know What Isn't So by Thomas Gilovich

This is one of the most influential investing books you will ever read. So many of our own foibles are detailed here that it is almost embarrassing. Everything from unsuspected biases to how we engage in critical reasoning comes under scrutiny. What it reveals isn't pretty. Despite the genius that is human achievement, it turns out that we are all very poor at comprehending complex data and analyzing risk.

This book will help you understand how your brain: processes randomness; overlooks evidence that is inapposite to prior beliefs; selectively perceives and reinterprets data; and engages in selective recall. It's how we all create an artificial story line to help make sense of otherwise incomprehensible data.

Once you finish this book, you will never look at investing the same way.

Note: This is purely psychology writing; If you prefer a more specific investing-related analysis, consider Why Smart People Make Big Money Mistakes and How To Correct Them: Lessons From The New Science Of Behavioral Economics by the same author (with Gary Belsky).

Hard-core fans of cognitive biases and economic anomalies (and other similar type of analyses) will also appreciate Richard H. Thaler's The Winner's Curse. Thaler is one of the most influential researchers in the field of behavioral economics.

If you want to see how cognitive and reasoning deficits manifest themselves, then the seminal book on the subject is Extraordinary Popular Delusions & the Madness of Crowds by Charles Mackay. There have been a lot more booms and busts then you imagine. This book details how they came about and their impact throughout history. Fascinating and instructive stuff.

Once you understand how our brains fool us into occasionally doing idiotic things -- funny, but it seemed perfectly reasonable at the time -- then you can start looking for ways to avoid making those gaffes. Humphrey Neill's The Art of Contrary Thinking will show you the way. He explains why "When everyone thinks alike, everyone is wrong." This intriguing thesis applies not only to markets, but to politics, academia, even sports.

What if human nature can never learn from its mistakes? What if we are doomed to repeat the aforementioned cognitive, reasoning and behavioral defects over and again? That provocative thesis is put forth by Robert R. Prechter in Prechter's Perspective. This is the book that explains why our own nature leads to history repeating so often.

A few caveats: I am not a devotee of Elliot Wave theory (Prechter's school of choice). Further, I hasten to add that many of Prechter's market calls have left much to be desired. However, his overarching perspective of human nature, and of history's cyclical tendencies, makes for utterly fascinating reading. Even though I found myself arguing with many of the premises in the book, I enjoyed this thoroughly. The cycle geeks out there will too.

In part 2 of the series we'll look at books focused on economics, Wall Street, technical analysis, fundamentals, shorting, and miscellany.

Apprenticed Investor: More Reading Ideas

12/7/2005 11:14 AM EST

In part 1, we looked at books that are helpful to the "Apprenticed Investor," from the history of markets to investor psychology. Today, we get into the details: economics, technical analysis, short selling, the fundamental approach, life on Wall Street and everything else.

Wall Street

If you can understand how the crazier things happen on Wall Street, you may avoid some investing pitfalls. These two books offer insight into that arena -- and they could just as easily be filed under how to raise problem children.

Fred Schwed's Where Are the Customers' Yachts? or A Good Hard Look at Wall Street. Schwed worked on Wall Street for a few years, and his book -- written 60 years ago -- is a delightful read, full of insight into both the Street and investors' psyches.

For those of you thinking about working in the industry, then Liar's Poker by Michael Lewis is for you. It provides a snapshot into a major firm circa the 1980s. As much as things have changed since then, they are still very much the same.

Economics

Understanding where we are in the business cycle -- expansion, plateau, contracting, bottoming -- is crucial to understanding where the markets will be in 6-18 months.

My favorite introductory econ book is Todd G. Buchholz' New Ideas from Dead Economists. Buchholz's survey of the history of economic thought is lively and informative. He avoids politics and academic squabbling, resulting in an extremely enjoyable, informative book. That's saying a lot for a subject that in the hands of a lesser writer would be dry and boring. Were I to recommend but one economics book for the layperson, this would be it.

Freakonomics: A Rogue Economist Explores the Hidden Side of Everything by Steven D. Levitt and Stephen J. Dubner. This is less a book about economics, and more a book about how to approach challenging problems from a logical perspective. Outside-the-box thinking combined with intelligence, creativity and mathematics makes for a potent combination. But don't let the math intimidate you -- it's a delight to read, and is very accessible to the nonmathematician/noneconomist.

The most serious of the econ books is Beating the Business Cycle by Lakshman Achuthan and Anirvan Banerji. Anticipating when the business cycle is about to turn is a trick most economists are exceedingly poor at; Achuthan and Banerji show you how to do it. If you find that the previous two econ books whet your appetite, then consider this your graduate-level reading.

Technicals

You learn technical analysis not by reading about it, but by looking at thousands of charts over the course of many years. That makes recommending any books on TA challenging. I picked the following because they either illuminated a particular segment of TA or were extremely accessible to the nontechnician.

Getting Started in Technical Analysis by Market Wizards author Jack Schwager covers all the basics: moving averages, trend lines, patterns, support and resistance. Another good book to get started with TA is The Visual Investor by John J. Murphy. Either of these will give you a broad overview of technical analysis.

My favorite of the new TA books is Trend Following by Michael Covel. Straightforward, easy to read, this book is rich in details about why trend following is such a successful strategy amongst some of the world's best-performing hedge funds.

How to Make Money in Stocks by William J. O'Neil. O'Neil, founder of Investor's Business Daily, created a quantitative and technical-based trading system called CANSLIM. Although I am not a follower of this methodology, it has much to offer to the novice. If you are an IBD reader or are curious about his philosophy, this book is a good place to start.

I've read several books that RealMoney's Gary B. Smith has recommended, including How Charts Can Help You in the Stock Market by William L. Jiler, and How I Made 2,000,000 in the Stock Market by Nicolas Darvas. I would suggest both of them to readers who want more details and background to how several successful technicians have made their fortunes in the past.

I occasionally find myself looking at a chart and wondering what the heck it means. That's why I have a small reference library on my desk. It includes:

• Technical Analysis from A to Z by Steven B. Achelis;

• Encyclopedia of Chart Patterns by Thomas N. Bulkowski;

• Japanese Candlestick Charting Techniques by Steve Nison;

• Technical Analysis of the Financial Markets by John J. Murphy.

Don't think you need a full reference library; all you need is one reference book to help you occasionally.

Short Selling

Surprisingly, there haven't been too many books on shorting -- or even on the art of selling. One I like is Sy Harding's Riding the Bear: How to Prosper in the Coming Bear Market. It came out in late 1999 -- how's that for auspicious timing! If the "buy & hold" investors had read this back then, they would have saved a lot of money. It's just as sensible today.

Another well-timed book is When to Sell by Justin Mamis. This was published in 1929(!). It's a bit slow going, but is filled with good observations about developing a sell strategy.

A basic approach to shorting is William J. O'Neil's How to Make Money Selling Stocks Short. Pure fundamentalists should be forewarned: it is very technically driven, and may be hard going for those with an aversion to charts. That's just as well; fundamentals can tell you what to buy, sell or short -- but not when. And timing is especially crucial when it comes to shorting.

Fundamentals

Given my inclination towards quantitative, trend, sentiment and macro economics, I am admittedly an outsider on pure fundamentals. But I have found these books to be valuable additions to my knowledge base.

Stocks for the Long Run by Jeremy Siegel is a terrific overview of all things equity. It's a great place to start, although many fundamentalists would advise you to begin with The Intelligent Investor by Ben Graham, which is considered the bible of value investing.

I find Warren Buffett intriguing. His annual reports are legendary; reading them is an education in itself. Start with Warren Buffett Speaks: Wit and Wisdom from the World's Greatest Investor by Janet Lowe. If you want the unvarnished words from the man himself, then choose The Essays of Warren Buffett: Lessons for Corporate America by Warren E. Buffett.

I would be remiss if I left out Peter Lynch. You can read any of his books, but I like One Up On Wall Street: How To Use What You Already Know To Make Money In The Market. Lynch shows how people can use their own experience to gain an edge on Wall Street. (We discussed this last year.)

One of the reasons I am not a fundie is that I don't do forensic accounting (bor-ing!). However, a readable approach to getting at those footnotes is Financial Fine Print by Michelle Leder. Those of you who are technically oriented may find this is a tough slog.

Supplemental

There were lots of worthwhile books that didn't make the cut for one reason or another. Some of them -- like Bull's Eye Investing by John Mauldin were a bit too advanced for the apprentice. Others cover a single topic. If the entire book can be adequately summed up in one line, then I can save you eight hours.

Irrational Exuberance by Robert Shiller (Jeremy Siegel is wrong: markets are risky, stocks are over-priced.)

Fooled by Randomness by Nassim Nicholas Taleb (Markets are very random; watch out for black swan events.)

The Tipping Point: How Little Things Can Make a Big Difference by Malcolm Gladwell. I thoroughly enjoyed this book, but if you want to save time, the punch line is that complex systems are nonlinear.

The Wisdom of Crowds by James Surowiecki. The book is thought-provoking and interesting but, unfortunately, I found too many logical flaws in it; further, it seems to be too tied to the efficient market hypothesis. (Bottom line: The crowd is right until they become an unthinking mob.)

Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor by John C. Bogle. (Wall Street charges too much, you are a lousy investor anyway, buy index funds.)

Chaos by James Gleick. Want to understand the mathematical science -- physics, actually -- of what really drives the market's behavior? Then this book is for you. (Bottom line: Markets are not truly random, but have qualities which include persistence, sensitivity to initial conditions and nonlinear dynamics.)

The (Mis)Behavior of Markets by Benoit Mandelbrot. Chaos theory as applied to markets by fractal geometry's creator. Warning: this book may make your head explode.

Apprenticed Investor: Plan Ahead

12/30/2005 7:13 AM EST

2005 was a challenging year for most investors, including the pros. It was a choppy, directionless market, with most of the upside performance crammed into just a month and a half from mid-October to December.

Think about what next year might bring. Is your portfolio ready for another choppy year? What happens if we have a big rally -- will you be ready to take advantage of it? Will you be able to preserve your capital if the market crashes?

Forget about missing out on Google's (GOOG:NYSE) or Apple's (AAPL:Nasdaq) huge run. Think about what could happen next year -- and get prepared for it.

Here are my suggestions:

How's Your Plan?

By now, you should have a fairly comprehensive investing strategy. If not, you should get one -- and fast. Improv is best left to stand-up comedians.

As the year comes to an end, it's a good time to think about tweaking your strategy. Are you comfortable with the risk levels you have? Are you well diversified? How is your asset allocation balanced between cash, stocks, fixed income, commodities, real estate? How much international vs. domestic exposure do you have?

You should be doing this sort of full portfolio checkup at least once a year.

Capital Preservation Strategy

How many dogs are still in your portfolio? Given the many ups and downs the market ran through this year, I'll bet that some of you are still holding onto trades that didn't quite work out. That points out a flaw in your risk management strategy.

On a related note, this is the time to review your stop-loss strategy. What stocks did you get out of in time? I'll bet there were some stops that saved you a ton of money. What did you do right with these?

Then there's the flip side: What stocks did you bail on too soon? How could you have corrected that? Very early in my trading career, I used to anticipate stops -- and sell out too soon. Had I kept to well-chosen stop losses, I wouldn't have gotten shaken out of those positions too early.

In our prior discussion of post-mortems we gave you a template for tracking your own trading.

Now is when that tool will come in handy.

Look for your best and worst trades, and Monday morning-quarterback them. Why did they work? Think about your process -- from selecting the stock and your trade entry, to managing your risk and selling the position. What did you do precisely right? Where could you have improved?

In the NFL, Monday is film day. Coaches and players watch game films to see what they did right, where they can improve, and to look for weaknesses in their opponents. No one wants to get tackled by a 300-pounder -- and no one wants to take a hit to the portfolio. Use your 2005 performance to improve your game in 2006.

Don't be discouraged if you didn't do as well as you would have liked; That's the whole point of self analysis -- to improve your game.

Check Your Sources

Mea Culpa: My biggest dog -- which shall remain nameless for compliance reasons -- came from relying, overrelying actually, on an analyst whose track record was much better than you might expect based on this particular low-priced pick. (No excuses: I pulled the trigger, I accept full responsibility).

My "dog" stock brings up an interesting issue: What's the track record of your idea sources? Do you use newsletters, stock screens, friends and family, brokers? How did they each do?

The majority of my trading activity comes from internally generated "top-down macro ideas" -- for example, I have exposure to oil, gold, Japan and Brazil. But I also buy individual stock names, and work with several very talented analysts. I keep a track record of all their suggestions and of how those picks have performed. I've even developed short list of "contras" -- people whose track records are so reliably bad, I fade their calls; if they say "buy XYZ," I think about selling it.

When you run all the numbers, I'll bet there are quite a few surprises among your idea sources.

Improve!

What are you planning to do to improve your performance this year? Reading the Apprenticed Investor is a good start, but what else are you hoping to accomplish?

As we've noted, this is an astoundingly competitive arena. And, we've talked about the need to constantly raise your skill level. What books are you planning to digest? What new sources will you be reviewing? How are you going to get better?

It is critical to learn something new all the time. It keeps your brain fresh and enlarges your skill set. Whether you are expanding your knowledge about markets, the economy, trading technologies, or behavior psychology, it is important to keep adding to your store of wisdom.

Develop an Expertise

We've touched upon this in the past, and now is a good to time to bring it back up. What is your specialty? What do you have a natural proclivity for?

It can be anything: You can be a market historian, a quant, telecom specialist, an option writer, a short seller, or a chart technician. One friend of mine manages to pull together all sorts of apparently unrelated economic data points to develop an investable thesis. Whether its thoroughbred sales or the number of new real estate agents, he can chart them and derive a previously unseen meaning.

If you are unaware of what your expertise may be, think about what you are naturally skilled at. Some people find that what they have an innate talent for are the things they particularly enjoy -- no coincidence there.

Having a specific area of expertise tends to improve your trading in other areas. I can't explain why that is, but experience shows it to be so.

It Used to Work

Pay attention to when something that used to reliably make you money suddenly stops. Are you doing something different? (You golfers know exactly what I am referring to). Sometimes, reliable strategies that work well in one area may not work elsewhere. If a particular methodology works well for small-cap stocks, it may not transfer to the big-caps.

Consider whether there are bigger issues than your trading mechanics. Is the market trying to tell you something? Just because shorting worked in October doesn't mean it will be successful in November.

Stay flexible, and be ready to adapt to changing market conditions.

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