The Tycoon Report

The Freight Train Theory: How to Benefit from Extremes

One morning as I waited at the railroad crossing gates for a long, slow moving freight train to pass through, I observed an interesting phenomenon. Most of the cars had remained in their places as the train first began to move through the intersection. But now after several minutes of box car after box car plodding by, the drivers were becoming impatient.

Suddenly one driver, then another, and then another, turned their cars around, and headed in the opposite direction to find another route. It was as if they expected the train to have an infinite number of box cars, which would never end. Although turning around would mean driving even further, they were willing to do it to avoid the pain of waiting for the train to end.

The irony is, as soon as the cars had left the scene, the last box car rolled through the intersection, and the crossing gates rose. It was a stunning example of how we do not seem to react to things until they reach their most extreme level, and how this is so often the worst time to take emotionally based action.

Can we apply this to markets such as real estate or stocks? Absolutely! Do you ever wonder why you have bought a stock at the top or sold at the bottom? This is why. When we first notice a new trend (rising stock price, freight train going through an intersection), there is a tendency to see it as a fluke, or perhaps interesting, but not enough yet to act upon it.

However, as the trend continues, it begins to pique our interest a bit more. We seek out more information to confirm the event. What does "The Tycoon Report" have to say about XYZ stock? CNBC? Jim Cramer? Wall Street Journal? Analysts?

Now we reach a stage of increasing anxiety. We have a little conversation with ourselves. "What if I miss the trend? Should I buy it now?" "Surely it has run up quite a bit in the meantime, what if it corrects right after I get in?" "Let me wait a little longer to see what will happen."

So we wait a bit longer, and sure enough, the stock moves higher. Now the anxiety turns to a greater fear of loss. "If I do not buy this immediately, I will miss out on all those gains that others are getting."

So finally you buy the stock. "Whew! I made a decision." About 12 minutes later, it pulls back, and you find yourself down a couple of percentage points by the end of the day. The rest of the evening you are cursing your luck, and are contemplating moving all your money into a CD! So what happened?

What happened was that the failure to act early on set yourself up to be caught in the trap of extremes. When a stock price rises or falls too much, it begets an opposite reaction from other investors. Those who bought the trend early begin to sell, locking in their profits. Traders using technical analysis see that the various indicators are now showing over bought readings, and begin to set up short positions. The stock market in general will often reverse itself when it moves too many standard deviations from the mean.

A similar scenario occurs when you sell a stock at the bottom. Your pain is relatively mild when the stock first begins to drift lower, but the pain increases in direct proportion to the amount you are losing. Finally when you can stand it no longer, and are afraid the stock will go to zero, you grit your teeth and sell.

Just about then, other traders are thinking, "Hey, the MACD signal on XYZ stock is flashing buy" or "Wow, nice dividend yield at this price", or "I have been waiting two months to get this price". But you have already driven away from the crossing gates, and now the gates are moving back up.

So what can we do instead? How do we overcome this tendency? It certainly is not easy, but we have to force ourselves to do the opposite of what our EMOTIONS are screaming at us to do. The logical mind does not say, "The stock is up 40% this past week. This would be a good time to buy it". No, it is our emotional state, the five year old inside of us all, that says "gimme that, I want it!"

So when you hear that inner five year old yelling his message, that is the exact time to sell short or just hold off on buying and wait for the inevitable retracement. And if your favorite stock is down a few points, re-evaluate the fundamentals (PEG ratio, debt, etc) or technicals (still above the moving averages?). You may just conclude that it is a better time to buy more, then to sell your holdings.

Many people use the ratio of bulls to bears (found in the Investors Business Daily) among investment writers as a contrarian indicator to determine when to buy or sell. When the writers are extremely bullish, that is the time to sell, and when the writers are extremely bearish, they buy with both fists!

A pet peeve of mine is the newsletter or CNBC commentator that tells you to buy a stock that has already jumped up 20%. Zacks is famous for this. I like my newsletters to make recommendations BEFORE the stock goes to the moon!

There is an old Wall Street saying, "Buy when there is blood in the streets". But how much easier it is to say those words than to actually do it! How many people are buying real estate or home builder stocks right now? Countrywide (CFC) is down another 4% today, and Toll Brothers (TOL) is down 2%. It takes guts to jump in when everyone else is jumping out.

But just remember, the end of the train will always pass through the intersection as soon as the other drivers have turned their cars around!