Editor's note: This is a special excerpt from Jim Cramer's book, Jim Cramer's Mad Money: Watch TV, Get Rich. To order your copy and read all the rules, click here.
Sneak Preview: When Fear Is Healthy
10. Don't try to smash iconic truths — try to make money. The conventional wisdom is conventional for a reason. Big institutional investors generally all behave pretty much the same way. Sometimes they look irrational or even stupid for buying and selling certain stocks at certain times.
I am often tempted to try to beat the institutions by figuring out the way they operate, looking for moves that seem stupid and using them either as opportunities to buy a stock they've knocked down for a bad reason or to sell a stock they've marked up for a similarly bad reason.
When the hedge funds and the mutual funds do the same exact thing, year after year, and it doesn't look like it makes them any money, don't jump to the conclusion that they're being hidebound idiots. Sometimes they're just being careful, and it pays to be careful. It doesn't necessarily pay to demolish the conventional wisdom; being an iconoclast is only rarely profitable.
So don't be arrogant when you see trading patterns that don't make any sense to you. Be cautious, figure out why the funds play the game the way they do, and if they're motivated by fear, respect that fear. Panic loses people money, but a healthy fear of unnecessary risk will only save you money.
I had to impose this rule on myself after my horrible experience recommending Montpelier Re Holdings (MRH - Cramer's Take - Stockpickr). Montpelier was a reinsurance company — that's an insurance company that insures regular insurance companies. When I recommended this stock on August 26, 2005, at $33.72 a share, I was being both arrogant and incautious.
I thought I'd spotted a great way to trade insurance companies. Every year during hurricane season the insurance companies would all get marked down. Lots of the hedge funds and mutual funds would sell these stocks in the fear that they would end up having to pay for a lot of hurricane damage. For the last few years the insurance companies would get sold down during this period in August and September, and then right after hurricane season, they would raise their premiums and bounce back even higher.
The hurricanes wouldn't do serious damage to the insurance companies because, as I told people who were watching, the insurance companies expected and budgeted for hurricanes. The selling by the big funds ahead of and during hurricane season was sheer panic — or at least that's what I said — and panic gives you a chance to make money. I said that all the talk of hurricanes and the worry about them was pure hype. If you wanted to make money, you had to see through the hype. My pitch was that hurricane season would cause the big institutions to act irrationally and sell off and mark down great insurance companies like Montpelier and you'd have a chance to buy them on the cheap before they bounced back up.
Let me give you a timeline of Montpelier's implosion after I recommended that people buy it on any weakness. On August 29, three days after I got behind Montpelier, Hurricane Katrina hit land in Louisiana and the levees in New Orleans started to breach. That day Montpelier closed at $34.03.
A week later, on September 6, the stock was at $32.29. That looked like the kind of markdown I talked about when I told people to buy the stock. Maybe it was a buying opportunity?
Maybe not. A week after that, when the monetary cost of Katrina for Montpelier — which had foolishly written most of the policies in the Southeast, essentially putting all of its eggs in one vulnerable, Gulf Coast basket — had started to become apparent, the stock closed at $25.99. If you were still listening to my original advice at this point, you might have seen Montpelier at $26 as the result of pure panic selling, making it a great buying opportunity. That would have been wrong.
Hurricane Rita made landfall in Texas and Louisiana on September 24, and on the September 26, the first trading day after Rita hit, Montpelier closed at $26.19. By October 3, a week after that, it was down to $24.87. Once all the financial damage from Katrina and Rita started to be calculated, and Montpelier started having to pay out a lot of money, the stock really got hammered. By November 7, the stock had come down to $18.75. As I write this book, Montpelier has traded roughly between $15 and $20 ever since. The stock got crushed and stayed crushed.
It wasn't just two bad hurricanes that hurt Montpelier. Because it had foolishly concentrated a lot of its business along the Gulf Coast, because it hadn't stopped insuring at-risk customers, as Allstate (ALL - Cramer's Take - Stockpickr) intelligently decided to do, Montpelier ended up having to pay out a lot more money than it actually had on hand. In order to pay off the policies it had written, Montpelier had to do a secondary public offering.
It had to create new shares of stock, effectively giving each existing share less of a stake in the company, and then sell those shares to raise money. Montpelier had to do this at the worst possible time, after its stock had already been smacked around by the two hurricanes. That meant it had to sell many more shares because it was getting less money for each share. Naturally, that helped keep Montpelier's stock price down.
Unfortunately, I can't blame Montpelier on chance or on the weather. I recommended the stock not in spite of the hurricanes, but because of them. I looked at this habit that the big institutional investors had of selling off insurance companies during hurricane season, and I didn't give it any respect. I tried to game it without understanding it.
If I'd had this rule at the time, I wouldn't have recommended Montpelier. I would have spent more time thinking about why these funds were selling insurance stocks, and I would have realized that they sold them not in panic, but because of a healthy, intelligent sense of fear.
You don't have to repeat the mistake I made in Montpelier. Don't write off the habits of your fellow investors, especially the ones that look stupid and incomprehensible. Usually, people have decent reasons for buying and selling stocks, and you should understand those reasons thoroughly before you try to game the supposed "stupidity" of your fellow investors.
Those are my ten new rules, gleaned from ten of my most embarrassing and educational mistakes on Mad Money. Some of these rules help introduce my new approach to the market, an approach that stresses understanding how hedge funds and mutual funds operate, because they control so much of the money in the market and think so alike that they essentially set stock prices. Other rules are just new lessons that I've learned from making mistakes and constantly reevaluating my judgments and actions on the show in light of those mistakes.
These new rules are every bit as important as my last set of rules in Jim Cramer's Real Money: Sane Investing in an Insane World, and they're also more up-to-date. It's important that you respect them, because I created them to stop you, and myself, from making the mistakes I've already made on the show. It's better for you to learn from my mistakes, which cost you nothing, than it is for you to learn from your own mistakes, because who knows how much money you'll have to lose before you come up with these insights.
Stick with my rules, add the new ones to the old ones, obey the disciplines laid out in the first chapters of this book about homework, buying and selling, and you'll have an edge on just about every other individual and institutional investor out there.
At the time of publication of this excerpt, Cramer had no positions in any of the stocks mentioned.
Jim Cramer is a director and co-founder of TheStreet.com. He contributes daily market commentary for TheStreet.com's sites and serves as an adviser to the company's CEO. Outside contributing columnists for TheStreet.com and RealMoney.com, including Cramer, may, from time to time, write about stocks in which they have a position. In such cases, appropriate disclosure is made. To see his personal portfolio and find out what trades Cramer will make before he makes them, sign up for Action Alerts PLUS. Watch Cramer on Mad Money at 6 p.m. & 11p.m. ET weeknights on CNBC. Click here to order any of Jim Cramer’s books including his latest endeavor Stay Mad For Life: Get Rich, Stay Rich (Make Your Kids Even Richer). While he cannot provide personalized investment advice or recommendations, he invites you to send comments on his column by clicking here.
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