Have You Been Swimming Naked?

By Joe Ponzio on July 30, 2007

I don't like to write about the stock market. Why? It's simple—whatever I write on Sunday night may very well be outdated by Monday's lunch. It is much easier, safer, and more comfortable to buy stocks in wonderful businesses and ignore the stock market than it is to trade stocks, analyze what the gamblers are doing, and try to predict the direction of the markets.

I spent yesterday afternoon at a barbeque where, not surprisingly, I "talked shop" with seven different people. Considering that, besides me, there were only 35 people at the party, 20% of the party was worried about the stock market. Take into account that I only knew 20 or so of them, I'd venture to say that the number was closer to 30%.

Swimming Naked

In three of his annual letters to shareholders (1992, 2001, 2004), Warren Buffett has said, in some fashion:

It's only when the tide goes out that you learn who's been swimming naked.

Buffett was speaking specifically of insurance and derivative businesses; but, the phrase could easily apply to the stock market as well. When the stock market is soaring, everyone is in up to their chins—splashing around and having fun. When it drops—as it always does—you quickly see who was prepared...and who is desperately running to deeper waters, hoping to cover themselves.

More often than not, naked swimmers drown.

The Stock Market Skinny Dipper

At yesterday's barbeque, I spoke with a number of stock market skinny dippers. Chief among them was Ted. Ted loves to talk about trading and the markets and wants to invest like Warren Buffett. Still, Ted has a gambling streak that forces him to chase down action—be it in the stock market or on the craps table.

Ted gave me a quick rundown of the last six months of trading. He lost a sum of money in NYSE Euronext (NYX), made it back in Apple (AAPL), lost it again in NYX, made it back again in Apple, and then lost it again in NYX. Each time he bought NYX, he figured that it was underpriced—at $106, at $94, at $88, and again at $76.

Ted's Justification

When people are making money in stocks, they rarely discuss their rationale for buying or holding. When they lose money, they are often quick to defend their losses. Ted was no exception.

At $106, NYX was a buy for Ted because, well, it had been going up. At $94, it was a buy because it had previously traded at $106. At $88, it looked "dirt cheap" and was ready to jump at least $10. In the end, how could he pass it up at $76?

When prodded for the value of NYX as a business, he admitted that he did not know. His rationale was based entirely on the past stock price—a price driven entirely by other peoples' judgment and trading.

The Tide Went Out On Ted

Ted wanted to ride the wave of NYX all the way to retirement. In search of a quick profit, Ted left his bathing suit on the beach and dove into Wall Street's finicky, unpredictable ocean. He didn't know what to expect from the ocean, and is now swimming deeper and deeper in search of bigger waves.

What Will You Do?

Are you constantly seeking short term profits? Do you try to make up for losses by making larger or more frequent trades? Do you buy stocks because the price is at a discount to...its price?

The tide always goes out. When it does, will you swim deeper to hide yourself? Or, will you sit on the beach with me and enjoy a glass of wine? After all, it's homemade and I have an extra glass—Ted doesn't want his.

Note: No, Ted is not his real name.

Also Filed Under "How to Think About Investing"

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• Mohnish: On Noise, Emotion, Gold And Change
• The Psychology Of Investing In Stocks
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