About Me 0050: How to Making Money

Everyone likes to be right and the easiest way to be right is to surround oneself with people and opinions that are predisposed to be similar to ours. When investing, it pays to be contrary. That sets you up to be wrong some of the time. The thing is, if you are right 60% of the time, and manage risk properly, there is a good chance you’ll make money. The most basic principle of investing is buy low and sell high. When doing this you’ll seldom hit the actual bottoms or tops; you are buying when the market is going down and selling when it is going up. That in itself is contrary to most retail investors’ practice of buying high and selling low.

Mutual Fund Flows and Sentiment as Contrarian Indicators

The majority of retail (casual) investors use mutual funds and ETFs (Exchange Traded Funds) to invest in the markets. Fund flows (deposits vs. withdrawals) are generally regarded as contrary indicators. This is a component of a broader series of indicators classified as investor sentiment that provide some insight into future directions of the market. The basic principle is: when many investors are bullish the market is more likely to go down and conversely a higher level of bearishness or negative sentiment indicates the market is likely to make a move higher. TrimTabs Investment Research reports on these fund flows and in a recent report stated:

We observed that equity prices tend to fall after equity exchange-traded funds (ETFs) rake in large sums of money. Conversely, the market tends to rise after equity ETFs post heavy outflows.

The report then issues this conclusion:

We have two explanations for the strongly negative correlation between equity ETF flows and future market returns. First, ETFs are traded mostly by retail investors and day traders. These are the least informed and most emotional market participants—the ones most likely to lose money over time. Second, we suspect hedge funds use ETFs when liquidity dries up. Hedge funds were forced to close individual stock positions during the credit crisis, so they bought equity ETFs instead. Equity ETFs posted large outflows in 2009, when liquidity improved.

These concepts are not really as complicated as they seem to be. It’s Economics 101. When demand outstrips supply, prices go up and when supply is larger than demand, prices go down. When funds are flowing into stocks, markets rise but at some point most people are invested and there isn’t enough uninvested capital left to drive prices higher.

Whatever the internal dynamics, the retail investors are generally the last to join in a rally and their main vehicle of investment are mutual funds and ETFs so large inflows into those instruments suggests that the market is near the top. That’s why many retail investors get the timing wrong and end up losing money. Nobody likes being wrong or losing money, it makes us feel pretty lousy about ourselves! This is borne out in the current rally where the retail investor is reticent to return to the markets after being burned so badly in the housing/banking crisis of 2008 – maybe one time too many in the last decade. As Adam Shell recently wrote in USA Today:

Yet, increasingly, investors on Main Street are not playing the stock market game with confidence like they used to, mainly because the game of making money has gotten tougher and more volatile since the financial crisis. Retail investors are buying fewer stocks. They are paring back on stocks and stock funds they already own. Instead, they’re moving into safer investments, like cash and bonds. “Investors are on strike,” says Axel Merk, president and chief investment officer at Merk Mutual Funds.

Fox News Doesn’t Make You Dumb. It Just Keeps You that Way

I don’t think the decision by retail investors to stay away from the markets is a good one. Markets have historically been a better investment than many other asset classes with the S&P 500 returning roughly a 7% annual rate of return. Stocks should, at the very least, be a strong component of a diversified portfolio. Instead of shying away from being wrong, investors – people in general – should expose themselves to a broader group of opinions, to alter unsuccessful behavior and improve decision making.

The findings of a new study, Misinformation and the 2010 Election, from the University of Maryland’s World Public Opinion show that 9 in 10 voters in the 2010 election believe they encountered information that was misleading or false, with 56% saying this occurred frequently. The study also concludes that those who watched Fox News almost daily were significantly more likely than those who never watched it to believe misinformation.

The bad news for FOX News viewers is that merely watching the channel appears to be toxic. Most voters believed a few whoppers during the 2010 election cycle. But daily watchers of FOX News believed more misinformation than everyone else.

The underlying problem uncovered by this study is that today’s news organization are not unbiased deliverers of the day’s events, these outlets are partisan interpreters of the day’s events packaged to appeal to their viewership or constituency. I don’t claim one network or source is a more egregious offender than another. Everyone is entitled to their opinions, but each carries a bias that should be understood before assuming what we are digesting is “news” and not opinion.

This Article is Biased

This article exposes some of my own biases. We all have them and those views can be positive as they give us the strength to make decision with confidence. Most of the stocks I own are lesser-known, yet-to-be-recognized small technology stocks. I short stocks that people recommend as buys, such as Coinstar (CSTR), and I shy away from momentum stocks with historically unjustifiable valuations. I believe you should never buy a stock for which you can’t make a historically significant case of undervaluation. In our markets his is contrary behavior, but it works, and it helps me sleep at night.

If we are making bad decisions, like buying market tops and selling bottoms like the recent bottom in 2008, it is positive to examine our biases and correct them where possible. The best way to correct faulty assumptions is to take in a variety of disparate view points and make informed decisions. We can’t do this confining our media consumption to sources that only reinforce our previously held views. Religion and patriotism should allow for independent thought and interpretation. We should all try to broaden our information sources in 2011 and perhaps we can overcome the ‘misinformation’ gap and make some more profitable investment decisions.

I hope technology positively affects your life in 2011 and all your stock investments are winners.

Steven Bulwa is an investment analyst with a focus on new developments in technology and the companies poised to benefit. He has contributed to TheStreet.com, Realmoney.com, Business Insider, Huffington Post and SeekingAlpha.com, among others. Visit www.bulwatechreport.com, or follow @BulwaTech, to learn about technology companies with true growth prospects for 2011 and beyond.

Even the long fawning UK press is now saying what any startup who has tangled with the music industry has said all along: Spotify will not be able to launch its free any-song-you-want-to-hear-the-second-you-want-to-hear-it service in the US. The Telegraph is reporting that at the last minute the labels demanded too much upfront cash, killing a hard negotiated potential deal.

This is sad, but not a surprise. Despite all the reasons consumers would love it and labels should be empowering a rival for iTunes, the labels are in defensive mode and have never been rational when it comes to these things. My issues with how Spotify has handled this aside, I actually didn’t want to be right on this one. It’s a sad day for users.

But this will be the interesting thing to watch: Does Spotify just roll these we’re-definitely-launching-in-the-US assurances forward to 2011, the way the company has the last two years or does it pivot, and focus on building a profitable site for Europe and other less guarded pockets of the emerging world? In the Telegraph link above an unnamed source says the year of brutal negotiations has forced Spotify to “stop and think about whether it can afford the move to the US and indeed whether it is worth it,” while the article quotes a Spotify spokesman as saying the negotiations are “on-going.” Oh, Spotify.

Here’s my advice: Pivot. Spotify has spent two years, and undoubtedly plenty of money and focus, fighting what was always a Don Quixote like battle to make the US labels listen to reason. This is the same industry who sued their users. It was a valiant effort, but it didn’t work. We can argue why they should back Spotify all day long, but the last two years has proven that they are just not going to listen without Spotify having to make some major concessions.

I think Spotify should walk instead of making those concessions. No matter how hot of a startup you are, money and time are exhaustible commodities. Spotify should start directing them at challenges elsewhere until there is enough of a sea-change in the US music market that labels see reason. Giving into the labels’ demands isn’t the answer. Instead, Spotify should retreat, build in other countries, perfect its model, get to profitability, and then come back to this market when the labels are weaker and Spotify is stronger, boldly proving cynics like me flat wrong. Use your international headquarters as an advantage, not a liability.

Spotify board member Klaus Hommels told me in an interview late last year that he believed Spotify may be the venture industry’s last-ditch effort to build an online music company. (Other than Pandora, of course, the online music company with nine-lives that finally won the right to exist.) He told the labels in negotiations that if they opted instead to drain Spotify’s venture cash and leave it for dead the way they have to so many others, they may never get another hot upstart to back. And that would resign them to an Apple dominated world.

He may be right. So why not play the long game, instead of the short one?

(Note: Don’t worry, I’ve put two dollars in the TechCrunch Pivot/Swear Jar.)

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Thursday, 6 January 2011

How to Making Money

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