Came across this article in the papers today which provides an interesting case study. I quote:

“Four months ago, judging myself to be the next Warren Buffett, I logged on to my Charles Schwab account and did something that in hindsight was astonishingly stupid, even for my own very long roster of financial screw-ups. I clicked over to the trading page and bought shares of Citigroup.

The company, like most of the big Wall Street banks then staring down the subprime meltdown, was limping along. The headlines were bad. The chatter on CNBC was pessimistic. I saw a bargain. I saw a company whose credit card bills and offers show up in millions of mailboxes every day. Just as soon as the banks got their write-offs out of the way, optimism would return to the sector. There would be more buyers of the stock than sellers. I would profit.

Now here I am today: My investment is down 22 percent. And I’m still holding on to the stock. Am I, as my wife and closest friends sometimes insist, the dumbest man walking the Earth?”

What went wrong?

The crux of the problem is that the trader used the wrong strategy for his expected reward. If short term profits are to the object here, the right strategy would be to buy into a company on its way up and not down. Buying on the way down is a contrarian strategy adopted by investors who believe that the company has been unfairly punished and will bounce back. Since there is no way of knowing when the shares will recover, contrarian strategies such as this are only advised by investors who have a medium to long term view and are willing to average down / hold for the requisite amount of time.

This is one falling knife that short term technical trader have no business trying to catch. Logic, which plays a big part in picking strategies, is the best advisor in these circumstances. It’s okay to compare yourself to Warren Buffett, provided that you also think and trade like him.

Also, short term trades must necessarily have short term profits and short term stops. It is possible to survive bad trades like this, provided that targets and stops were set, which they weren’t. Being able to fly from one point to another requires you not only to know where you are going, but to possess an properly functioning aircraft that can takeoff, fly and land without crashing. You must check its wheels, landing gears, navigational instruments, radio etc. In trading terms, these are the targets, stops, bet sizes and formulas for knowing when to increase or decrease positions. Entering into a trade without considering all these things is like taking off in a plane and then worrying about whether it can make it to the other side in mid-air.