A Bad Bear Stearns Trade Can Teach Investors a Lot
It doesn’t have to take a decade to learn some valuable lessons.
Bloomberg, January 6, 2020
What do you do when a trade goes awry?
That was the subtext of a Wall Street Journal column on Christmas Day, “Eleven Years in the Making: Breaking Even on JPMorgan’s Purchase of Bear Stearns.”
“It only took 4,209 days, but I am finally even!!!” So declared Stephen Bearce, now a broker at Wells Fargo. He had taken a flier on 100 Bear Stearns shares amid its epic collapse from $171.51 — its record closing price on Jan. 12, 2007 — to where Bearce bought it at $30 a share on Friday, March 14, 2008. By the following Monday, it was sold in a pre-bankruptcy fire sale to JPMorgan Chase & Co. at $2 a share in stock. (Eventually, JPMorgan raised its bid to $10.) It took more than a decade for gains in JPMorgan shares to bring Bearce’s investment back to break even.
Why did Bearce buy stock in Bear Stearns? It was a speculation on the chance the investment bank would be taken over at a premium, making him a quick buck. The lesson offered in the column — “Money is made slowly and lost quickly” — doesn’t truly do the trade much justice.
On a hunch there might be other more useful insights for investors, I reached out to some of the savviest traders and portfolio managers I know. What follows are some of their takeaways from our email exchanges about that trade gone bad:
Avoid Rationalizing Errors
John Roque, managing director of equity research at Wolfe Research, urges analysts: “Admit you’re wrong immediately. If you’re on the sell side and publishing research, your (buy-side) clients will have more respect for you if you admit you made a mistake when you are wrong. Continuing to justify your thesis while your thesis fails is a serious mistake.”
Roque also points out there are other factors beyond the opportunity cost: “the cost of being emotionally burdened by a losing position.” Traders must consider “the cost of your time and efforts being monopolized by your losing position” including the time you spend “rationalizing the holding.”
Beware of the Sunk Cost Fallacy
Howard Marks, co-chairman of Oaktree Capital Management, which oversees $122 billion in institutional assets, points out that the original “sunk cost” of the purchase price is irrelevant: “The money is gone from your wallet, and that fact cannot be reversed. The question is what you should do today.” Marks notes in the Bear Stearns trade, the JPMorgan purchase price means $28 is gone, and what you have is an asset worth $2. “The question isn’t whether you should hold it from a cost of $30. The question is whether you would buy it today for $2.”
Past actions should not determine present ones.
Skip the Mental Accounting
Eddy Elfenbein, manager of the Focused Equity ETF who blogs at Crossing Wall Street, points out: “The worst investor in the world is the person who bought a stock, then realized it wasn’t the company they thought it was and they’re now sitting on a loss.” The investor who refuses to sell because they “don’t want to take the loss” has not realized yet that the loss of capital has already occurred. Waiting to break even is a form of “mental accounting” and a poor use of capital. “The stock is completely unaware of your purchase price.”
Consider Opportunity Costs
Peter Mallouk, CEO of Creative Planning, a $45 billion registered investment adviser, observes: “I look at each position I own regularly and ask ‘Would I buy this today?’ If the answer is no, I sell.” He adds, “Investors should not forget their goal is to see capital grow, not merely return to break even.”
J.C. Parets, a certified market technician and founder of the All Star Charts blog, makes a similar point, suggesting that all portfolio holdings should be treated as capital. “If this was a trade sitting in cash, would you buy this stock, or is there something else you would do with it?” He notes that unless you can confidently state, “Yes, buy this stock right here right now,” then you know your answer. “You sell it and redeploy the capital. Any position you hold is as good as cash. That gets forgotten a lot.”
Listen to What the Market Is Telling You
Nicholas Colas, co-founder of DataTrek Research, advises against fighting the tape: “Never buy a new low or short a new high.” Stepping in front of that momentum can become an expensive error – a lesson he learned as a portfolio manager at SAC Capital. “When a stock is in free fall you wait days (if not weeks) for it to stabilize. And when it makes a new high every day, if you must short, short small.”
Counterintuitively, Colas notes the trade in Bear Stearns was “LUCKY to get back to flat. This is a success story, not a cautionary one.”
Always Have an Exit Strategy
Parets observes what he describes as an obvious but overlooked strategy: “Always know where you’re getting out before you even get in.” This includes having a sell discipline for both winning and losing trades. The key to successful trading is managing your exits regardless of how the trade turns out. “Markets don’t care what your cost basis is.”
Own Your Errors
When you make a trade that turns out to be a loser, admit it, own it and learn from it. Not admitting an error sets up your portfolio for more losses in the future. Ray Dalio’s book “Principles” is based largely on the concept that when mistakes happen, they present an opportunity to learn. Those who fail to accept this not only don’t improve, they become more likely to fail again.
Holding an investment until it breaks even is merely a way to refuse to acknowledge an error. A sale won’t happen unless and until you admit your thesis was wrong.
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I originally published this at Bloomberg, January 6, 2020. All of my Bloomberg columns can be found here and here.
