Calling BS on market maxims (and 9 trading rules)

Hang around markets long enough and you're bound to hear the same sound bites over and over. You know the kind I am talking about; the common market phrases that people trot out either when the situation suits or when they have nothing else to add the conversation.

• Buy when there is blood in the streets
• Buy low, sell high
• Sell in May and go away

Whilst many of these stock market maxims are based in history and still hold water today, the events of the past few years have challenged some others. In this wire, I’ll dive into a few that have become questionable. I’ll also share with you the nine most important rules I learned back when I was but a humble trader (many, many moons ago).

1. The stock market rises and the bond market falls

Whilst this relationship held true for many years, things completely fell apart at the start of 2022. Bonds are viewed as defensive because they typically aren’t as volatile as other asset classes, but from January 1, 2022, until mid-October of the same year, the S&P 500 fell around 25% and the Total Return Bond Index fell around 18%. So much for diversification.

Of course, many would point to the 15 years of expansionary monetary policy from central banks post the GFC, followed by the pandemic and the subsequent policy response, as distortions in the system and the reason for this relationship breaking down – and they would be right. But it still broke down nonetheless. 

2. A rising tide lifts all boats

Another market maxim that, until recently, held water (pardon the pun). But the rise of the “Magnificent Seven” in the US, and the fact that they carried the S&P last year whilst the rest of the market stood still, is firm proof that the rising tide doesn’t always lift all boats.

Again, this could be nothing more than a short-term distortion, with the impact of AI driving the share prices of the Seven in an unsustainable way. For what it is worth, many of you believe that the Seven won’t continue at the same pace in 2024. In the recent Outlook Series survey, we asked:

The "Magnificent Seven" rose 92% on average in 2023 accounting for nearly all of the gains for the S&P500. Indicate your agreement or disagreement with the following statement: 'This trend will continue in 2024.'

More than 60% of you disagreed with the premise above.

The chart below highlights the returns of the Seven through October last year, compared to the broader S&P and the remaining 493 S&P companies. The chart was sourced from Goldman Sachs and FactSet, and is the most up to date chart I could find.

3. The market is efficient

I’m not sure where to begin with this one. If you believe markets are efficient, then you would simply buy a passive index fund and get what you get. And many more people are taking this option, as shown by the recent Australian and US data summarised by my colleague, Glenn Freeman, in this wire:

Funds

The numbers are in: ETFs outstripped managed funds for the first time in 2023

View

But an efficient market is defined as a market where prices reflect all available, relevant information. No doubt, we are moving closer to that. More people, have more information, more readily than ever before. But to say that everyone has all necessary information at exactly the same time and will respond to it accordingly is a bridge too far. So long as humans are involved in markets, there will always be some degree of inefficiency, and those inefficiencies will be exploited by those who have better information, access, computing power and, most likely, artificial intelligence.

4. You can’t go broke taking a profit

I never liked this one. Technically speaking, it is correct. But it is also true that you can cost yourself a LOT of money if you take a profit too early and don’t maximise your investments when they are performing for you.

For this maxim to be true, it also implies that you never have any losses – and this is not realistic. Consider a situation where you invest $10,000 in each of five stocks and you make 10% on four of them ($4k profit) and then lose 50% on the last one ($5k loss). Your net loss is -$1000, despite an 80% strike rate (four winners and one loser). If only you had cut that loser and let those profits run. Ultimately, you want to be right, and sit tight (a couple more maxims for you to digest).

5. The Super Bowl theory

OK, this is not a maxim. And let me say right off the bat that it is nothing more than a statistical anomaly. But the Super Bowl is in a couple of weeks and I’m an NFL fan, so you will have to bear with me.

In American Football, there are two major conferences (each with 16 teams), which are a hallmark of two football leagues merging into what is now known as the NFL.

The Super Bowl theory posits that if a team from the American Football Conference (AFC) wins, then it will be a bear market (or down market), but if a team from the National Football Conference (NFC) wins, it will be a bull market (up market).

The theory was "discovered" by Leonard Koppett in 1978 when he realized that it had never been wrong, until that point. So, how has the theory fared since?

As of the last Super Bowl in 2023, the predictor had been right 41 out of 56 games, a 73% success rate. In this year’s Super Bowl, the Kansas City Chiefs (AFC) are facing off against the San Francisco 49ers (NFC).

Let’s go 49ers!!!

Nine Trading Rules

Below is an extract of an article I wrote a long time ago, when I was trading markets for a living. These were the nine rules that I Iived by and whilst they have a trading focus, they are applicable to longer-term investing as well.

There are many more trading rules, some of them good, some of them pointless catchphrases. These are the nine that I have found most useful over my journey and that I am happy to share with you because they are impactful.

1. PROTECT WHAT YOU HAVE

This is the rule to rule them all. Really, it’s the only rule that matters. You MUST protect what you have. A former colleague of mine used to tell me that if you made it to the end of the year and still had what you started with, it was a good year. Anything on top of that was a bonus. I didn’t understand it at the time but there are so many good lessons tied up in it. Firstly, trading is hard. Really hard. It doesn’t come easily so make sure you treat trading - and the market - with respect. If you don’t, it will rob you blind. Secondly, defence before offense. Don’t get carried away with the millions you could make, before you have made them. Even then, you better have a fine plan to protect those millions once you have earned them. Ultimately, have some humility and protect your capital the way a mother bird protects her young. And remember, if you lose all your capital, the game is over.

2. TRADE WHAT YOU SEE, NOT WHAT YOU THINK

This rule came to me later in my trading journey and it was an epiphany. I went down just about every rabbit hole possible looking for the holy grail of trading, i.e. the method that guaranteed success. I researched different indicators, studied a million strategies, and even spent countless hours building trading systems. Then, this came along and straightened me up. It allowed me to simplify things, to realise that less is more, to understand that there is no holy grail, and to pay attention to the price action and what it is telling me.

3. CUT YOUR LOSSES, LET YOUR PROFITS RUN

An oldie but a goodie. You have to know when to hold ‘em, and know when to fold ‘em – god bless you Kenny.

I first happened across this maxim in Reminiscences of a Stock Operator, by Edwin Lefevre (if you’re serious about trading, make sure to read it). A lot of people use it as a sound bite. There is more to it than that. It’s really telling you that you need to have a plan for managing risk.

Any dummy can buy stocks. People who make money have detailed plans for how to maximise their upside, and limit their downside. Get this right – no mean feat – and you’re well on the way to trading profitably.

4. NEVER, EVER…EVER ADD TO A LOSING POSITION. EVER

Did I make myself clear? Some investors might like to ‘average down’ – that is, buy more of a stock when it falls so that they have a lower average entry price. They have a long-term view and, even when buying more, the position being added to probably still only represents a small portion of their overall portfolio. Adding to a losing position when trading can see your position size, and therefore potential loss, accelerate quickly. And that would violate rule number 1. So, don’t do it. Just don’t.

5. KEEP EXCELLENT RECORDS

Document what you do. Have a trading plan. Log your trades and have a structure that allows you to review what has happened. Your trading outcomes are your data. As we are all becoming increasingly aware, data is very important and super powerful these days. Keeping good data will allow you to look back over what has worked and what hasn’t, and make adjustments to improve your outcomes. If you don’t have good data (or any data at all) from which to draw conclusions, you might as well just throw darts at a dart board.

6. DON’T FALL IN LOVE WITH STOCKS

It’s hard not to do. Just as parents secretly have a favourite child, traders will undoubtedly have favourite stocks. But just as you wouldn’t tolerate your favourite child taking your vintage sports car for a joyride (Ferris Bueller style), you should not tolerate a favourite stock costing you money. When behaving badly, a favourite stock needs to be treated like any other and eradicated from your holdings. Do your best to treat stocks as vehicles that will help you to create or lose money. Nothing more. Don’t worry about whether they make buggy whips or sell tangerines (watch Danny DeVito’s speech in Other People’s Money – that reference will make sense). If you can do that, you will maintain the requisite objectivity.

7. CONTROL YOUR EMOTIONS

Don’t panic and don’t get too exuberant. The market will test you. You will find yourself with a fistful of stocks, all showing a profit, and then you will wake up to a 5% demolition on US markets. You will have to move quickly. Figure out what you will hold and what you will dump. You will need to find order amongst the chaos.

These things can and do happen. I have lived them. They are stressful times. Even more stressful if you don’t have a plan and you can’t control your emotions. The other side of it… don’t punch the air when everything is going well. Stay humble and, more importantly, stay focused. It will amaze you how many times in your trading career that just as huge profits are mounting, suddenly they are yanked from your grasp – usually when you’re not paying attention because you are too busy punching the air.

And finally, don’t worry if you miss a great trade. There will be more… and more… and more. The market isn’t going anywhere (unless capitalism fails and then we’ve all got far bigger problems).

8. PAY ATTENTION TO YOUR TRADING COSTS

These can be a killer and so many people don’t pay attention to them at the beginning. They don’t understand the impact of their trade frequency and their trading costs on their account size. They simply trade a lot and think, if I have more winners than losers, I should be making a heap of money. Depending on your account size and how often you trade, transaction costs could be anywhere from 5-50% of your total capital over the course of a year. Imagine having to make a 50% return just to cover your trading costs. Yes, bizarre, but I have seen it happen. Treat trading like a business, be aware of what is coming in AND what is going out.

9. DEVELOP A TRADING PLAN

Developing a plan, sticking to it, and refining it for improvement will put you ahead of 80% of your competition. Yes, it’s a lot of work but it is well worth it. If someone told me I could improve the probability of my trade (any trade) being a winner by 80%, I would be all over it. You should be all over this. So, what you are waiting for? Get on with it!

Over to you

Is there a market maxim that grates you the wrong way or no longer stacks up?

What about your favourite trading/investing rules?

Make sure to share them with us in the comments section below.