Learn to Love Irrational Markets

At The Motley Fool, we're all about buying businesses for the long term, not trading stocks for the short term. At times, this seems an illogical way to look at a stock market that appears to act more irrationally by the day. Talking heads on CNBC talk about the trade of the day -- every day. Commentators discuss the emerging technical patterns that we all have to prepare for. We don't just have to deal with bears and bulls; are "perma-bears" and "perma-bulls," whatever those are. 

So what's an investor to do in this schizophrenic environment? Take a deep breath and remember to put these contributors into perspective.

The charts are speaking to me
My favorite type of market irrationality is that of the chart readers. They pretend to be sage investors who can tell what a stock is going to do just by the look of its chart. There's support here and a peak there. This chart clearly shows a double top, while that one shows trouble ahead. I have yet to see a chart reader rehash which calls he or she got right and which ones were wrong, so it's hard to take them seriously.

The latest chart-reader to make me laugh was an article on Marketwatch titled "Apple charts signal trouble ahead." This must be good!

"If AAPL declines just a few more dollars, below $644, it'll complete a false upside breakout pattern on the weekly chart -- and then watch out below." Oh no! Apple (Nasdaq: AAPL  ) is doomed because of the false upside breakout pattern! Call your broker! Sell, sell, sell!

But wait. I finished the article, and it said, "If AAPL rises above $685 this week, its MACD will turn up, negating its bearish divergence." So, I'm supposed to be short at $644, but if the stock goes to $685, it's going to go higher. There goes $41 per share, and now I'm supposed to buy the stock? What kind of advice is that?

I'm going to go out on a limb and predict that Apple's long-term earnings will drive the stock in the long term. I like the stock's value and products, which I think are both more important than what the chart says. But if the author wants to sell me shares for $644 today and buy them back at $685 later this week, I'll be happy to make that trade.

How many chart readers do you know?
If chart reading is such a great investment method, there must be some famous chart readers, right?

I can name long-term investors like Warren Buffett, Peter Lynch, and Benjamin Graham. Even big names of more recent times, such as David Einhorn, Eddie Lampert, and John Paulson, make big long-term bets on companies or commodities to make their fortunes. They're not chart readers.

There's a simple reason that reading charts isn't a way to beat the market in the long term. If the trend always held true, everyone would do it. If everyone did it, no one would be able to profit from it.  

High-frequency trading: Come one, come all
Something that often scares investors is the prevalence of high-frequency trading in the market. These traders bring nanosecond trades, flash crashes, and strategies so complex they would make most retail investors' heads spin. It's normal to be intimidated by the complexities of high-frequency trading, but why do we care what these traders are doing on a day-to-day basis?

I look at my brokerage account every few weeks just to make sure it's there. I'm in the thick of the market every day, but I've never worried about what a single investment does each and every day. If more investors did the same thing, high-frequency traders could just trade with each other -- a zero sum game.

Since high-frequency traders care little about the fundamental value of a company, they can create great dislocations in stock prices, which long-term investors can then take advantage of. 

Playing a different game
Another thing long-term investors need to keep in mind is that a lot of big market participants aren't investing the same way we are. Banks like Goldman Sachs  (NYSE: GS  ) , JPMorgan Chase  (NYSE: JPM  ) , and Morgan Stanley  (NYSE: MS  ) -- and even hedge funds, which generate a lot of revenue from trading -- are making markets. Their role in the market is to buy on the bid and sell on the ask, which should inherently be profitable. As retail investors, we're buying on the ask and selling on the bid, and we're not going to win against market makers, so why try?

I don't complain that my car dealer makes a profit on each car it buys and my car loses value the second it leaves the lot. Dealers can buy a car at a lower cost than they will sell it to me for; that's the way the business works. The difference is that in the car business, if you have a computer glitch, you won't likely lose $400 million in a matter of minutes the way Knight Capital (NYSE: KCG  ) did. For that risk, I'm happy letting market makers play a game that plays to their advantage. They're taking a risk on short-term moves so I don't have to.

The good thing is that the craziness these traders bring also provides opportunities for investors who are on the lookout for undervalued stocks.

Take advantage of the irrationality
Trying to fight the market on a day-to-day or minute-to-minute basis is a losing battle for retail investors. Instead, we need to focus on tried and true long-term investments and take advantage of opportunities when irrational markets misprice them. Apple, for one, may be in a double-barrel bottom spiral on the charts, but with a trailing P/E ratio of 14.7, $120 billion in cash, and products selling so fast the company can't keep them in stock, I see a long-term buy.  

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Fool contributor Travis Hoium manages an account that owns shares of Apple. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.

The Motley Fool owns shares of Apple and JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of Apple and Goldman Sachs Group. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. The Motley Fool has a disclosure policy.
We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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