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How to Deal with Knee-Jerk Market Reactions

InvestorEducation / Learning to Invest Jun 08, 2008 - 08:23 AM GMT

By: Money_and_Markets

InvestorEducation

Best Financial Markets Analysis ArticleJack Crooks writes: This past week was a roller coaster ride in the currency markets, and it sure ended with a bang. I'll get to the big news in a second. And I'll also tell you what to make of this market.

But first, I want to do a quick day-by-day rundown of what happened in the currency markets ...


Tuesday:

Ben Bernanke revealed new concern over inflation and spoke directly about the weaker dollar.

Knee-jerk reaction in the currency markets: The dollar jumped.

Thursday:

European Central Bank President Trichet signaled interest rate hikes may come as early as July.

Knee-jerk reaction in the currency markets: The euro soared.

Friday:

U.S. Non-farm Payrolls were reported down 49,000 (better-than-expected) for the month of May. But U.S. unemployment leapt by half a percentage point to 5.5% (worse-than-expected).

Knee-jerk reaction: The dollar tumbled. The Dow lost almost 400 points. And on the same day, crude oil skyrocketed by more than $10 a barrel!

Looks like it's time to queue up the recession talk again. And don't forget that inflation is a big concern — Big Ben even said so!

Did this tag-team of Fed inflation rhetoric and freshly disappointing economic data open up the flood gates? Sure might have.

Federal Reserve Chairman Ben Bernanke's leadership ability is being called into question as crude oil prices explode and unemployment soars.
Federal Reserve Chairman Ben Bernanke's leadership ability is being called into question as crude oil prices explode and unemployment soars.

Stocks don't like it when the Fed gets lovey-dovey with inflation. In an already tight lending environment, if the Fed leans toward drying up access to money (or away from doling it out freely), who's going to keep what little leftover cash they have invested in bogged-down companies that still may be many months away from honest-to-goodness recovery?

It's been surprising how well stocks have held up so far. It's likely the keep-hope-alive mentality was buoying the Dow and the S&P. But with every new fundamental defeat how long can investors' minds stay focused on the light at the end of the tunnel? It's dimming rather quickly and should be practically invisible if the Fed keeps its attention on rising prices.

And for the buck, it comes down to one thing: Sentiment. We can argue all day for a dollar rally, or a collapse to new lows. And we have. But what matters is how the dollar is perceived by those who are trading it.

If you're off trading solo it's not always easy to keep a firm grip on market sentiment.

But protecting against most of the bad and positioning for most of the good is a crucial step toward successful trading.

Here's a little guideline for today's markets ...

Hope Can Hurt; Fear Can Help

I read a book on trading many years ago that said before every trading day begins, you must ask yourself: How badly can I screw-up my account today?

It sounded a bit blunt, and an odd way to start the morning. But I've found this simple approach is a great way to focus on the key element that will determine long-term success in any asset market — stocks, bonds, commodities, currencies, and even real estate.

It's risk.

In terms of the risks today, you probably have your own personal checklist. You might be including:

  • Inflation fears brewing.
  • Potential time-bomb of derivatives.
  • An overvalued stock market.
  • Falling real estate values .
  • On and on into infinitum ...
John Pierpont Morgan (April 17, 1837 – March 31, 1913) was an American financier, banker, philanthropist, and art collector who dominated corporate finance and industrial consolidation during his time.
John Pierpont Morgan (April 17, 1837 – March 31, 1913) was an American financier, banker, philanthropist, and art collector who dominated corporate finance and industrial consolidation during his time.

No doubt these are market risks. And they do inspire fear. But there's nothing we can do to fully eliminate risks. We can neither keep them from happening, nor forecast them with complete accuracy. But you can control the small stuff, like your individual account risk.

It's obvious some of us can handle more risk than others. The best single phrase about how much investment risk one should take comes from J.P. Morgan, who told a worried friend, "sell down to your sleeping point."

Translation: If you're lying awake at night, worrying about your investments, you are carrying too much risk.

I have found the simple "screw up your account" mantra very useful for risk control, so much so that I have it printed across the top of my "trade sheets" where I record each of my trades, risk levels, and reasons for the trade.

Why does it help me? Because it forces me to define the level of risk I will take BEFORE I enter an investment position. The reason I have capitalized "before" is because before you enter the investment you still have at least a degree of objectivity left in your brain.

AFTER you enter an investment position, your objectivity is flushed down the drain and replaced with something very dangerous — hope.

Here's an example of how I define my risk in a currency trade BEFORE putting on a trade ...

I look for a key technical level — some type of chart support area, or basic trend line that will tell me that the dynamics of supply and demand in the market have changed. Or put another way: if prices reach this level I am wrong because the market has proven me wrong.

At this point I'm out of the trade with a loss, period, end of story. I can always reenter the trade if it makes sense. But because I have exited, I somewhat regain that modicum of objectivity to better evaluate price action.

Always remember: Being in cash is an investment position; and it's sometimes the best position!

There is an old market adage: Bull markets climb a wall of worry, while bear markets flow down a river of hope. It's natural to hope our losses will subside and be afraid our profits will go away. And it's also why we are tricked by Mr. Market.

Legendary Wall Street trader Jesse Livermore summed it up best when he talked about reversing our natural impulses in the market:

"When the market goes against you, you hope that every day will be the last day — and you lose more than you should had you not listened to hope. And when the market goes your way, you become fearful that the next day will take away your profit and you get out — too soon. The successful trader has to fight these two deep-seated instincts."

We must turn hope and fear inside out. We must fear our losses will get bigger and cut them short. And we must hope that our profits get bigger and let them run. In these choppy markets, defining risk beforehand is the best thing you can do.

Best wishes,

Jack

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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