Experiences of a Retail Investor

In this story, Richard Howard tells his story in the first person, as he lived it.

I "retired" from Digital Equipment Corporation in June 1993 at age 53. I was sick of the corporate world of deadlines, performance reviews and action items; uncertainty about layoffs and budget cuts; inept management, lack of corporate direction and waste of resources; endless meetings resulting in nothing; working on projects that were cancelled or resulted in no profitable revenue; empire building, management by committee and consensus, team building, departmental and corporate reorganizations. In short, I was sick of going to work. Each morning as I parked my car in the Digital lot and got out to head for the building, the most important question I asked myself was "How soon can I leave work today?" I needed a change.

On May 25, 1993, I arrived at the office around 9 am and checked my e-mail as usual. The only message was from my boss asking me to call him as soon as possible. I called him to learn that the funding for my favorite project had been eliminated just four weeks after approval. I was not overly surprised but felt very annoyed and asked him to put me on the upcoming June layoff list. I had made this decision weeks before anticipating the funding cut. He asked me to think about it over the Memorial Day weekend and call him on Tuesday when we returned. I told him I would call but I wasn't changing my mind. On Tuesday I reaffirmed my request to be laid off. He replied that he'd see what he could do.

I knew you couldn't ask to be laid off, but I was sure my request would be granted. I composed an e-mail to my boss and his boss stating that, due to the funding cut, "I had no more contributions to make to Digital." I sent the e-mail and started to clean out my office. After an hour or so I left for home. A week later my boss called and said I was on the June layoff list. We agreed to meet on June 28 so I could sign the termination agreement and turn in my badge. After 15 years at Digital, I was going to be free!

My Wife's Reaction

When my wife arrived home from her job late afternoon of May 25, I greeted her at the front door with a big hug and said, "I quit." "What? " she replied. I related my conversation with my boss and sending the "no more contributions" e-mail. She replied "That ought to get you laid off." And then she asked, "What are you going to do after that?"

For the last three years I had not been happy at work and I had been asking myself that very question. "What would I do if I didn't work at Digital?". I knew I needed an income so I couldn't just quit and do nothing. Since 1982 I had dabbled in the stock market. In 1987 just after the market crash, I began to put money into the market regularly. After surviving the crash, I realized I had the stomach for the inevitable ups and downs that stocks deliver so I decided to become an active investor. With money I earned from a part-time teaching job, I stashed cash in a money-market account. This pile would become instrumental in my post-Digital plan.

We spent the evening discussing our plans and in the end we were both in complete agreement. I would leave the corporate world and pursue full-time trading in the stock market. Her support was crucial.

The Layoff

I was formally terminated at Digital on June 30, 1993. I received a generous severance package of six months' salary and an extension on a previously issued options grant of 500 shares of Digital stock, which eventually terminated as worthless. Digital stock plummeted and the subsequent purchase by Compaq didn't revive the stock. But the severance money bought me time to construct a plan to generate income. I knew I was not going back to work in high tech or teaching and had decided to trade stocks to earn my living. I was 53 years old, had 10 years of experience casually buying and selling stocks. I had $113,000 in cash saved from the part-time teaching job and other stocks in an IRA account and more stocks in a long-term buy and hold dividend reinvestment program. My first task was to inventory and organize this smattering of stocks and cash.

The Three-Pile Plan

During the summer of 1993 I developed a plan. I knew I could start receiving my Digital retirement in 1995 when I turned 55. Also, I decided to activate my Social Security at age 62, which would be in 2002. Therefore, I needed to generate cash for my expenses from 1993 to 2002. I decided to use the $113,00 cash pile as my cash register account. Out of that pile, I would draw money for monthly expenses and trading money.

The second pile, the stocks in dividend reinvestments plans, would be available if I ran out of money in the first pile. My intent was not to use money from the second pile unless absolutely necessary. This diversified portfolio of about 100 stocks included a mix of stocks from many sectors. My largest positions were in: Pfizer, Coca-Cola, Pepsi, Colgate, NiSource, Home Depot, Lucent, Real Estate Investment Trusts (REITs) and electric utilities.These were buy-and-hold stocks not to be traded. I reinvested all dividends to accumulate shares for the long term. I regularly invested new money to purchase shares using dollar-cost averaging.

The third pile, an IRA, would be available at no penalty when I turned 59 1/2, but I didn't want to touch it until after that. I would trade in this account but not use it for immediate income needs.

Start of Trading

I started trading stocks in June 1993 while still finalizing the three-pile strategy. I worked with my broker, a vice president with a nationally known full-service brokerage house. In the parlance of the brokerage professional I was called a retail client or retail investor. I had had an account with my broker since 1982. I knew him well and enjoyed working with him. I also knew he had much more experience than I and that I could learn a lot from him. I surmised I could do better with his help than striking out on my own so I was willing to pay full commissions because I trusted his suggestions and judgment. Soon he discounted the commissions because of my frequent trading. Yet I never considered the commissions I was paying were a significant factor in my trading decisions. If I made money, I made money.

Finally, I reasoned that when you have dental problems, you go to a dentist. You can't drill your own teeth. Same with your investing decisions. Get advice from a professional you can trust. But make sure you can trust your advisor. I'll talk more about trust and external advice later. Don't make important investment decisions by yourself when you're learning how to trade.

In 1996 I opened an account with an on-line discount broker. The first time I attempted to access my account, the on-line site was down. I never used it again. I learned the interaction with my broker was far more beneficial than the savings on commissions from a discount broker.

Trading Activities

1993 through 1997 were active trading years. I was not a day trader - a person sitting at a computer trading minute by minute. I wanted to have a life outside of the stock market. I made a few trades each month. I only bought individual stocks long. I went short once, lost money in a few days, covered the short position and never again shorted a stock. I rarely traded options and never bought on margin. My strategy was simple: take quick profits, avoid large losses by taking small ones. Never get into a situation that could lead to a catastrophic loss. Always have cash on hand for the next trade. I never made a huge amount on any trade, although I did make $5,000 one morning on a lucky trade. I was always in the game. I made sure I never ran out of cash to make the next trade and pay my bills. I had a very compelling motivation. If I failed to get it right, I would have to go back to a regular job in the real world. After a taste of freedom and independence, the last thing I wanted was a real job and reporting to a boss every day.

Filtering Information

I soon learned that I was flooded with too much information about stocks and the stock market. My problem became how to sort all the information coming at me, discard the junk and listen to the advice that was based on sound data not just hearsay, opinion, hype and speculation. I coined the term "Wall Street Buy Propaganda Machine." Every where I looked, magazines, newspaper columns, brokerages, books, seminars, newsletters, radio, television and the Internet, the message was the same - buy, buy and buy more.

I realized that mutual funds and brokerage firms make their living by selling you funds, stocks and bonds. Also, most newsletters, magazine and newspaper financial columns told me what to buy - but never what to sell. Many investors accept these recommendations without performing much if any critical analysis. People spend more time deciding which car to buy than which stock to buy. I was one of those investors until I was burned a few times.

Doing My Own Research and Making My Own Decisions

In the fall of 1994 I loaded up on a retail stock that I read about in a $200-per-year newsletter to which I'd subscribed. The newsletter guru touted the stock and I went along with his recommendation. I visited one of their stores during the Christmas buying season to get a feel for the operation. I didn't like the store or its merchandise, which was a hodgepodge of consumer products and inexpensive jewelry. After Christmas the store reported lower-than-expected same-store sales, and the stock fell. I felt betrayed by the terrible advice, and sold the stock before it plummeted. The company rapidly went out of business and the stock went to zero. How could have the "expert" been so wrong?

After that experience I cancelled the newsletter because the writer would tell you when to buy but never when to sell. That was my "near death experience" in my trading life and I didn't like the feeling.

But I did learn three powerful lessons, which ultimately saved my trading career: BE SKEPITICAL, DO MY OWN RESEARCH and RELY ON MY OWN JUDGMENT. I concluded that successful investing is not a hobby or entertainment. And it's not particularly fun. It's time-consuming, and takes hard work, practice and perseverance to get good - to make money. You can listen to other people's recommendations but can't blindly accept them. You must conduct your own due diligence to ensure that you separate the charlatans from the legitimate purveyors of information and recommendations. You must be a committed investor.

Before you buy any financial product, get to know the person who is recommending it. Ask why he or she is recommending the product to you. Be skeptical. Don't assume the advice is always in your best financial interest. In fact, don't assume anything. For example, you no longer can blindly trust audited financial statements from publicly traded corporations. Beware of a corporate executive who touts the future performance or his company. He or she is the company's ultimate cheerleader.

Always ask why I should NOT own an investment. Look for what can go wrong. Ask, what happens if I lose all the money I paid for this investment? Always know your exit (sell) strategy. Can you sell any time you want or is the investment illiquid? My worst investments were limited real-estate partnerships, which I bought in the 1980s when they were the rage. General partners sold units (shares) to retail investors at high commissions extolling the likelihood of long-term capital gains when the real estate was sold. Unfortunately many of the partnerships paid too much for the properties and sold them for pennies on the dollar. I had no say when I could sell and had to wait for 10 to 15 years to receive my pittance. It was a humbling experience.

Moving forward from that time I decided to conduct all my own research and make my own decisions. I'd stand or fall on my own. If I goofed, it was my error. If I succeeded, I thanked someone else for their input and recommendations, but I thanked myself for the my decisions and good luck.

Admitting Mistakes

I quickly learned that I had to admit I had made a mistake when a trade went bad. In 1994 I bought stocks of copper and nickel producers thinking they would bounce up. I knew that such stocks were extremely volatile but I was willing to take the chance. Shortly after I bought the stocks, they started to move down. I was down about 10% when I sold all my shares. They continued down another 30%. I lost money on the trades but I avoided a disaster by recognizing that I was wrong about the direction of the price movement. I got out and had money available for another trade.

When you accept how unexpectedly and rapidly stocks can turn down, you quickly learn methods to preserve your trading capital. I never used formal stop losses (where shares are sold automatically at a predetermined price). Rather, I watched the stocks daily and after the confirmation of bad news and a drop in the price, I simply sold as quickly as possible. If the stock bounced back after I sold it, that was fine because I met my objective of preserving my money. I learned not to beat myself up when stocks moved up immediately after I sold them.

Learning from Each Trade

New Yorker magazine published an article in February 2002 about the contemporary practice of medicine. The point of the article was that doctors learn their craft by literally practicing on patients. While a doctor can read about and discuss a new technique, he or she must actually perform the technique on a patient to learn how to do it. Doctors must "practice" to get good at what they do. The same is true for trading stocks. To get good (make money) at trading stocks, you have to trade stocks. You'll make lots of mistakes and lose money, but if you analyze what you did you will learn. The trick is to get good before you run out of money. I had to learn this the hard way. After some hefty losses in 1994, I was getting quite discouraged. I thought if I had to worry this much about trading, I should get a real job where at least I could count on a regular paycheck. But the thought of going back to work, literally drove me to learn how to make profitable trades. When I learned that each trade was a new learning experience, much of the emotional burden was lifted. I began to enjoy trading because my winners outnumbered my losers.

Riding the Bull Market

I must confess that I lucked out in the timing of my trading career. In the 1990s the market kept rising and covered up a lot up of my trading mistakes. I could make a bad trade, then almost immediately make money on another trade. If I'd been in a full-fledged bear market, I wonder if I would have survived. In bull markets you can get fooled into thinking your success is because of your skill, but in reality it might be due in some part to luck. The book "Fooled by Randomness" by N. N. Taleb discusses in detail the notion of luck versus skill. I like to think my trading success was mostly from skill, but I recognize luck played a role.

Status of the Cash Register

Recall the cash register started with $113,000 and its job was to fund my trading and monthly expenses until I was 62 and started to receive Social Security. I made enough money in 1993 and 1994 to cover my expenses. 1995 was a very profitable year. After all expenses the cash register's value was $187,000. I slowed down trading in 1996 and started to drain the cash register. I had a few trades from 1996 through 1999. From 2000 through August 2003, I did no trading.

Why I Sold?

Why did I sell when friends and most stock-market professionals held their stocks and many continued to buy? As the stock market continued its relentless climb in 1999, I became very leery of the prices people were paying for stocks. Many technology stocks advanced 30 to 60 dollars in a few weeks and some in a few days. I was concerned that prices were simply rising too fast and too high. I had not invented The Complete Trading Model (CTM) so I couldn't use it to evaluate price patterns. But I was telling anyone who would listen that the market would eventually crack. I didn't know when the bull market would end but I was sure it would. I didn't believe the popular hype that said "it was different this time, the Internet changes the business cycle, and stocks will make you rich."

But I needed solid data to support my intuitions. I felt history might provide clues about the future of stock prices, so I began to study long-term price charts for the DJIA, S&P 500, Nasdaq and Nikkei 225. My first insight about the importance of understanding the long-term rhythm of stock prices occurred when I used Excel to chart long-term prices for the market indices. The charts showed the short- and long-term ups and downs in prices over time. It became obvious that prices were moving far above their long-term trendlines. On the other hand the Nikkei provided evidence of a long-term decline in prices after a price bubble.

Next, I charted the inflation-adjusted S&P 500 and saw clearly multi-year periods of up moves followed by long periods of down moves. Based on these price patterns I reasoned that after the current bull market ended stocks would trade down or flat for several or many years.

Finally, I constructed a very revealing chart that showed the ratio of the Nasdaq to the DJIA. Taking the weekly closes for the Nasdaq and DJIA from finanace.yahoo.com, I divided the Nasdaq close by the DJIA close and plotted the ratio. The chart showed a spike in the ratio indicating the Nasdaq was far above its long-term ratio with the DJIA.

Now I had an easy-to-understand measure other than pure price that I could track continuously in real time. As the ratio continued to rise, it indicated how distorted the Nasdaq prices had become. I became more and more convinced prices could not continue on their current upward path. Two scenarios could bring the ratio back to historical levels. The Nasdaq would have to fall or the DJIA would have to rise. As the ratio fell below 2, I studied the long-term price charts of the DJIA and Nasdaq and concluded that the Nasdaq was too high so I sold all the technology holdings in my trading account. (I didn't use the CTM buy-and-sell methodology because I hadn't perfected it until later.) On April 10, 2000 I sold: Oracle (ORCL) at 74 11/16, Dell Computer (DELL) at 53 7/8, and LSI Logic (LSI) at 66 5/8. I had sold ICGE at 199 7/16 on December 28, 1999 and America Online (AOL) on November 26, 1999 at 162 5/8.

Soon after I sold my technology holdings, I read Irrational Exuberance by Robert Shiller. His long-term price-to-earnings ratio chart clearly showed the extreme over valuation of the stock market. I loaned the book to a good friend, who after studying the charts, sold a large portion of his stock holdings.

2003 and Beyond

As planned, the cash register is nearly empty, but my IRA and dividend reinvestment stocks grew in value since 1993 and are available for my future use.

Sometimes I think that if I had continued to work until age 62, I would have saved and invested a lot more money and my retirement accounts would be worth much more than they are today. That probably would be true, but what of it? I don't need the extra money. I now have enough money for my lifetime and then some. I decided some time ago that when the pile gets large enough, it doesn't have to be any larger.

Will Grand Theories Help?

I suspect that I may have this relative lack of greed in common with many other retail investors. In my experience, we tend to have definite, rather modest goals. This means that the major theories about the market may not be very helpful to us. We probably can't buy or track enough stocks to benefit much from diversified "random walks", a popular academic theory that holds that stock picking is impossible, and that a random selection of stocks, will, on average do as well as any other. Selecting and buying enough stocks to have a representative random sample is difficult, and, in a way silly, since with an index fund you can "own" the whole market (a 100 % sample in statistical terms). Therefore, the "random walk" theory (from the title of Professor Burton Malkiel's famous book, A Random Walk Down Wall Street) is in practical terms simply advice to buy index funds and not time the market.

Many retail investors don't have the almost infinite time horizon implied by "buy and hold" strategies; most often we become interested in stocks in mid-life, as I did. Whether or not a stock's price reflects all that is known about it, what matters to us is what we know, or don't know about the stock. As long as there is uncertainty in our minds about a stock, we need to try to conquer it with some form of knowledge.