There's no glory in being a pessimist. Very rarely does the person who makes a doomsday call get championed for being correct. But, without us skeptics and pessimists there wouldn't be a market, because we all know that stocks don't just go straight up.
That being said, I'd like to remind you that it's perfectly OK to be a pessimist. It doesn't mean you have to walk around wishing bad things for your neighbor or become the gray cloud of your social circle, but it can provide an alternate and possibly realistic view of the market or a stock that we can admit is overwhelmingly biased toward the bulls.
Understanding that there are two sides to every trade, I've devised three reasons why it's OK to once in a while rain on the bulls' parade.
Reason 1: It's good to know your investments' weaknesses.
We'd be fools (with a small "f") if we blindly flew into an investment without fully understanding possible weaknesses. Investing involves doing your research and understanding not only your side of the trade but the reason why the other person is making the opposite trade. Consider yourself a stock market sleuth and pretend that you're investigating why someone would want to beat up your investment.
Take Bank of America (NYSE: BAC ) . It's one of my core holdings and I fully expect it to have a phenomenal year. However, that doesn't mean I don't see challenges for the stock. I fully understand that European worries, the ongoing Countrywide Financial saga, and a weak housing market could easily put more pressure on the stock. I remain very committed to my long position but also understand where the opposite side of the trade is coming from.
Reason 2: It reminds us that you can make money on stocks in either direction.
I'm fully aware that not everyone is comfortable with the concept of shorting, or betting against, a stock. For one thing, unlike buying a stock, you could actually lose more than your initial investment and your gains are capped at a maximum of 100%. However, shorting or buying puts can actually be a valuable tool that you can employ in your own portfolio to keep from over-levering to the long side.
I'll use my portfolio as an example yet again. Early last year, despite being a long-term silver bull, I saw a gross disconnect between the price of silver and its historical returns so I purchased puts on the iShares Silver Trust (NYSE: SLV ) . As fellow Fool Alex Dumortier set out to prove last April, silver's returns have historically reverted to the mean. In short, that meant that it was likely that silver's fortune will reverse in a big way soon. Luckily for me, the trade worked out perfectly. But more importantly, it allowed me to recognize that silver prices aren't going to go straight up forever despite my long-term bullishness on the metal.
Reason 3: It keeps your emotions in check.
One of the greatest detriments I've encountered in my 13 years of investing is allowing my emotions to get in the way of my better judgment. Although I want to think positively about my ability to predict every pick correctly, being pessimistic and therefore realistic about my ability to pick stocks and understanding that I will not always be right has allowed me to let winners run and to wisely cut losing picks early on before they became a strain on my portfolio.
Akamai Technologies (Nasdaq: AKAM ) is one that I was able to get right last year. As a play on cloud computing, Akamai boasted a 13% growth rate, yet was only valued at 13 times forward earnings (at the time). I could have taken a quick profit, but instead chose to ride out Akamai's movements for a few months, keeping my expectations realistic all along. All told, I netted an extra 30% in profit because I went into the trade with realistic expectations and remained skeptical of my motives in wanting to get out early.
If you take anything away from what I've written here today, it should be that it's perfectly OK to be pessimistic about a stock or the market in general. Even if you're too gun-shy to take action on your pessimistic instincts, just having them will make you a more informed investor.
Are you doing anything to hedge your portfolio against possible downside? Share your ideas in the comments section below.
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