Until recently, I would have told you that only thing in common between long-term mutual fund investors and short-term stock traders is that both are trying to make money.
Today, I’m telling classic buy-and-hold fund investors that they could learn a lot from stock jockeys.
I certainly have in the three months since I became editor at RagingBull.com, a site where veteran traders write about their day- and swing-trading strategies. In taking the job, I helped to develop the site’s ethics policy for journalists, the procedures that ensure that the site avoid conflicts of interest. Effectively, they make it impossible for me, personally, to pursue any short-term market action, to follow or profit from the moves recommended by the site’s trading experts, whose commentaries I edit.
While I can’t trade myself, it has been impossible to work so closely with traders and not pick up an appreciation for how they do their jobs. What I was surprised to learn was how many tactics traders use that long-term investors could profit from.
Mind you, I’m not advocating that average mutual fund investors start trading their mutual funds or making moves at a regular pace. Countless studies show that fund investors who over-trade their accounts wind up lagging the markets and the average funds; fund investors are better off buying-and-holding a slowly-evolving asset allocation – the way they do in a target-date or life-cycle fund – than trying to trade their way to bigger profits.
But they will be better buyers and consumers of funds if they apply the tenets of small, individual traders to their process.
Here are five things that long-term buy-and-holders should learn from short-term traders:
Trade the plan. Good traders plan their trades, and then trade their plans. They don’t let the market dictate moves, they don’t let winners run past where they have the right balance between risk and reward, they take appropriate profits or losses, and they offset aggression with patience, getting in only when the price, conditions and time are right.
Traditional fund investors have an ideal holding period of forever, and they review their performance and portfolio infrequently, so that if a fund’s performance drifts or fades, they don’t make moves until real problems fester.
Buying and selling funds based on their ability to deliver to expectations is a way to make sure that the entire portfolio remains solid.
Use the right tool for the job. Traders look for the right way to make the most from each trade, whether that means buying stock, using options, juicing the situation with a leveraged exchange-traded fund or whatever improves their chances for success.
Too many fund investors live by generalities, buying new funds in order to diversify their portfolio without giving it much more thought than “I don’t own something like this.”
They wind up with a collection of funds, rather than a portfolio where each investment has a purpose.
If a fund can’t improve your portfolio – if it doesn’t have a specific role to play – it probably makes more sense to wait until there is a real, solid reason to add something new to your holdings.
Quantify risk and reward. Savvy traders look for situations where the odds of success are in their favor, where the potential upside is much bigger than the probable decline if they make a mistake.
Fund investors set expectations by looking at past performance, figuring that positive results are likely repeat and maybe eyeing a fund’s worst year as the “bad as it gets” result they might see in a downturn.
Instead, fund investors should have specific expectations for every type of fund they buy, an acceptable range of performance. They should know what to expect from an asset class, and where – relative to the category average – they expect returns to fall. Settling for a laggard that falls short of the assets and/or the average fund has long-lasting consequences that are much bigger than most people recognize.
Keep emotion out of it. Traders set limit orders and follow plans because it removes emotion from the process. They’re not buying a “favorite,” they’re using a tool; the minute it’s not useful or there is something better suited for the job, they move on.
Fund investors let emotion rule the day; they let winners run, find it hard to rebalance back to their plan, and rely as much on hope as on hard data. Too often, emotion breeds inertia; it’s why investors hang onto funds (“It was good to me once”) or fall for charismatic managers (“He looked so good on tv”) rather than letting numbers dictate the next move.
Be willing to accept and move on from mistakes. Traders know they can’t win them all; they know what they are willing to lose if their investment thesis is wrong, and they get out — accepting a minimal loss – when the market works against them.
Fund investors hang on, hoping to get back to break even, and then typically sticking around when it happens as if it was an achievement. This is why there’s at least $1 trillion in overall fund assets held by mediocre performers and laggards; there’s never a good reason to hold a bad fund.
Chuck Jaffe is editor at RagingBull.com; he a nationally syndicated financial columnist and the host of “MoneyLife with Chuck Jaffe” (moneylifeshow.com). He is a long-term investor and does no short-term trading of stocks, options or ETFs. You can reach him at email@example.com.