Playing Defense - Playing Defense for 2003 A Psychological...

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Playing Defense for 2003: A Psychological Strategy for Navigating Risk and Reward Brett N. Steenbarger, Ph.D. Note: A version of this article was written for MSN Money in late 2002 after the market had lifted off its October bottom. The principle of identifying an initial pullback from a candidate breakout move and using that as a stop once the move reasserts itself is a trading strategy that works across a variety of time frames. Here’s how I applied it on a large time frame. On the heels of a third consecutive down year, investors find themselves Janus- faced in January, with one eye toward value and opportunity and the other toward risk management and safety. To paraphrase the military strategist Clausewitz, “Everything in investing is very simple, but the simplest thing is difficult. The difficulties accumulate and end by producing a kind of friction. . . . This tremendous friction . . . is everywhere in contact with chance, and brings about effects that cannot be measured, just because they are largely due to chance.” The present market seems particularly friction-filled, with the looming chance events of war, terrorism, and international turmoil. How is one to resolve the dilemma of Janus during 2003, pursuing opportunity on one hand and maintaining adequate defenses on the other? In this article, I will draw upon insights from both psychology and market history to provide a measure of guidance for willing but wary investors.
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A Tale of Two Markets Consider two stock markets, seeming mirror images of each other: Market A is on a tear. The NASDAQ 100 Index ($NDX) is up over 30% in less than two months, leading the general market higher over that period. Among the NASDAQ winners, tech stocks are the champions, rising almost 75% in that brief period. Small stocks are outperforming large ones, as money from an easing Federal Reserve finds its way into entrepreneurial firms. This has led the weekly advance-decline line of NYSE stocks to new all-time highs. With interest rates declining and money supply flourishing, the economy appears poised for continued growth. Though the market is selling at a robust 26.7 times current earnings, investors do not seem worried. Reflecting the vigor of Market A, over 50% of respondents to the Investors Intelligence survey are bullish, doubling the number of bears. Market A, it would seem, has its face turned upward, toward further gains. Market B, on the other hand, is in the throes of the bear. For the first time since the 1940s, the Dow Jones Industrial Average ($INDU) is about to complete its third consecutive down year. It has been a sickening plunge, shaving 75% from the NASDAQ 100 average ($NDX) and over 40% from the S&P 500 Index ($SPX). The economy is responding only in a tepid manner to repeated Federal Reserve easing, with little if any private-sector job creation. The dollar has fallen below parity with the Euro and, in the face of global tensions, gold is trading at a multiyear high. Burned by corporate
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Playing Defense - Playing Defense for 2003 A Psychological...

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