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Mr. Market
A fallacious stock market strategy
Here is a story that has features in common with John Scarne's The $400,000 Roulette Win, which is a story about a high roller using a fallacious roulette system and winning, not because of the system, but because of good luck. Mr. Market is using a stock trading system that he thinks is yielding him high profits, when indeed he is just about breaking even in a very strong bull market. The flaw in his system is quite obvious to anyone who knows the most respected rules of trading, yet it escapes its user and many of his readers. The rule he is breaking is to cut his losses quickly and let his profits run. He does exactly the opposite.
Mr. Market is an amateur stock speculator named Ernie Barsamian. He is a chemical engineer and also a graduate of the Wharton School of Finance. He sets a modest price target at about a 20% advance for his new trades and liquidates if that target is reached. If that target is not reached he merely holds on to the position regardless of any loss. All that keeps him in business is that he has three successful trades for each unsuccessful one.
On his home page he lists 30 successful trades since March 11, 2004, all liquidated at gains ranging from 15 to 20 per cent. Also listed are ten unprofitable positions, still held with losses of from 7.9 to 71.4 per cent. The worst of these is MFLX, which he bought on March 6, 2006 at near its all-time high of 60.5. It failed to reach his price target of 69.7 and he still holds it at 17.3. He updates his results about once a month and his latest update shows further declines in his losing positions. Apparently he will take no action unless these stocks recover and reach his arbitrary price target. We cannot calculate the rate at which he is losing money in this way because we don't know the size of his position in each stock; but as an approximation, if he loses all of the capital invested in his losing trades he still will have recovered 90% of his capital through his winners. If he loses only half he is ahead by 2%.
It is easy to see from Mr. Market's first table on his home page updated July 23, 2007 that his average current loss on his losing trades is 42.6%. Let us inquire how much more he could have made on some of his successful trades if he had not been content to take a quick profit:
7/27/07
Stock Sold at Went to Current price Comments
PDX 35.04(1) 60.35 54.99 Still worth holding
DECK 31.97 107.78 107.78 Still worth holding
SPF 30.36(1) 50 15 Eventually a loser
MCRI 21(1) 33 31
CMN 29 33 14.96 Got out in time
CME 259.67 600 556.50 Maybe should be sold now
DW 22.14(1) 38 33.75
(1) Adjusted for 2:1 split
These should be enough to prove the point that Mr. Market passed up some good profits by selling his winners too soon.
Mr. Market's biggest error is in his evaluation of his performance. He advertises:
I have 30 consecutive profitable trades of 15% or better. How is this possible? Every day there are hundreds of stocks setting new highs, no matter what happens in the overall market. Many of these stocks are still at very reasonable valuations. Afraid of buying stocks at their highs? Think of it this way: a new high is really a future floor for companies with solid financial underpinnings. Quantitative momentum modeling makes it easy to identify stocks that can continue this upward momentum trend. I am $$$ MR. MARKET $$$. I AM HUGE!!!
First of all, it is not correct to say that every day there are hundreds of stocks setting new highs, no matter what happens in the overall market. Every day the number of new highs and new lows are reported in the financial press. At the start of a bull market there will be a few new highs. When a bull market is well underway there may be over a hundred new highs on the New York Stock Exchange, but not more than two hundred. During a bear market there may be no new highs and many new lows. We are talking about new highs and lows in a 52-week period.
He has 30 consecutive profitable trades merely because he has not liquidated his unprofitable ones. They remain in his portfolio and continue to lose money. According to the tables on his home page he has not closed a position at a loss since April 5, 2004 although he has ten losing positions and some of the losses are considerable. Although he has three profitable trades for every unprofitable one, one must bear in mind that we have been in a very strong bull market since 2003.
It is interesting to compare Mr. Market's style in self-evaluation with Warren Buffett's. Warren Buffett recognizes his unprofitable trades and even apologizes for them to his shareholders. Mr. Market merely sweeps them under the rug. Warren Buffett is a winner because his figures add up. Mr. Market thinks he is a winner merely because he doesn't add up all his figures. At the very least, Mr. Market's financial practices represent poor accounting that would not be tolerated if he were handling other people's money.
Mr. Market's Stock Picking Forum
Mr. Market's Home Page
My conclusion is that stops don't work in this strategy. I should mention that in my Marketocracy fund I am regularly culling stagnant stocks and I also use some kind of a mental stop loss. But I compensate this by letting my winners run; see my reports. I really don't know if it is any better than what Ernie is doing.
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