Play the Stock Market Like the Wealthy

NEW YORK (TheStreet) -- A good friend of mine, who calls himself "The Parrot Investor" because he likes to copy the investing behavior of the notably successful, wrote me after reading one of my missives.

"Polly has a problem," he confessed. He explained he had received contradictory messages from two of his investing mentors. One said now was the time to be cautious and stocks were about to correct. Another was saying, in essence, "Don't worry, keep buying."

"Is the message that I cautiously pile into stocks right now? At times it's hell to be an imitator. Is it easier to pick an adviser or a stock? Maybe it's time to lose my bird brain before I lose my shirt. Now if I could just pick the right mentor," my puzzled friend lamented.

Perhaps I answered too hastily, but here's a portion of how I replied. "The right mentor isn't someone selling newsletters or a zillionaire like Warren Buffett. It's someone just like you who has your level of investment resources and is consistently employing the wisest and most relevant (that fits this time of program trading and flash crashes) strategies, disciplines and lessons learned."

Then I waxed metaphysical and wrote, "A hint: It's not your ego or mine, but if you look in the mirror and stare into your eyes you'll see him. He's your best self, your wise, observing, peaceful, soulful intelligence. It is with us always and it makes the best mentor possible."

My "best self" is telling me to study the behavior of wealthy investors. A study heralded in financial journals of late reveals the findings of three economists from three well-respected business schools (Columbia, Harvard and NYU's Stern School of Business).

The economists analyzed the positions and trades of more than 260 of the super-wealthy between the years 2000 and 2009 (a harrowing period of time for traders and investors). The data came from an undisclosed private firm that consolidates account info for the super-wealthy.

The results confirmed that the wealthy capitalize on their "comparative advantages" and the strengths they uniquely possess. Since they're very wealthy they have access to special offerings like private placements and longer-term investment opportunities.

The study determined the uber-wealthy park about 20% of their investable capital in hedge funds and various types of venture capital deals and private equity opportunities. These rich people don't flip their holdings much and they tend to choose carefully and hold on for longer periods.

The super-rich rebalance their accounts (or pay an adviser to do it) by taking profits on a portion of their "winners" and allocating the proceeds to other asset classes that haven't fared as well. Yet, during times like late 2008 through March 2009 they acted like most humans and froze in fear and uncertainty.

It interested me greatly to read that the total value of stock positions held by the rich families in the study plunged from $8 billion in mid-2008 down to $3 billion in March 2009. That's even worse than the 36% drop in the major market indices during that same period of time.

As U.S. Treasury bonds soared during that period of time, if they would have sold the bonds they owned and reallocated the proceeds into oversold, extremely cheap blue-chip stocks, the study calculated that the super-wealthy group would have been more than $500 million richer by March 2009.

I want to point out that most investors and traders become victims of their own emotions. That's why they don't, on average, outperform the stock market benchmarks. Nor do they beat the "smart money" on Wall Street.

That's why I'm a big proponent of using a stealth trailing stop alert system like TradeStops, which I personally use every trading day. When a stock hits a price at a chosen percentage below or above my predetermined comfort level I receive an email alert at the end of the day. This way I can limit my losses and let my winners run!

Now let me share with you the type of trade that a wealthy person might make. I want to thank Frank Curzio, the editor of the Small Stock Specialist who also writes for The Growth Stock Wire for sharing this specific sector and stock idea.

The semiconductor index, as represented by the SPDR S&P Semiconductor ETF ( XSD), has been rising like gangbusters since mid-April of this year, as you can see in the six-month chart below.

XSD Chart XSD data by YCharts

This looks like an impressive "breakout" that may ascend further. A wealthy investor might buy XSD, or buy a company that is one of its holdings that has strong fundamentals, pays a nice dividend and looks technically strong.

One example is Cypress Semiconductor ( CY), which trades at a forward (one-year) PE of less than 15 plus it offers close to a 4% dividend.

In a press release last week the company announced a quarterly cash dividend of 11 cents per share payable to holders of record at the close of business on June 27. This dividend will be paid on July 18, the company said.

This dividend will be treated for tax purposes as a return of capital for U.S. tax purposes for the 2013 fiscal year. Wealthy investors like that because it won't be a "taxable event" but will reduce their cost basis on what they paid for shares of CY. If those shares are held for 12 months or longer, any profits will be taxed as long-term capital gains.

Why would a wealthy investor want to own shares of CY? "Cypress is a leader in touchscreen chip technology. The company is well-positioned to benefit from telecom's massive spending spree. It has contracts with 80% of the companies in the telecom industry, including AT&T ( T), Verizon ( VZ) and T-Mobile. It also supplies international telecom companies, including China Mobile ( CHL), according to Curzio.

Now here's how a wealthy investor might play CY. She'd buy an initial amount, say 124 shares at $11.16 (wealthy investors would buy much larger lots, but I'm trying to keep this simple). Then she'd sell a "naked" long-term put option that expires the third Friday of January 2015 with a strike price of $10. After commissions she'd pocket nearly $179 for selling this put.

She can buy to cover the put at any time. But she doesn't intend to do that and her obligation is that if CY closes below $10 a share on that Friday in January 2015 she'll have to buy 100 shares at $10. Factoring in the $1.79 ($1.79 times 100 shares is how she was paid the $179) she received for selling the put option her net price-per-share would then be reduced to $8.21.

In the meantime she's made herself an instant "synthetic dividend" of $179 to sweeten her purchase today of 124 shares of CY, which cost her after commission $1,391.79. By dividing $179 by that $1,391.79 she experiences the same results as if she was paid a 12.86% instant dividend on her purchase, knowing that she may have the obligation to buy another 100 shares in January 2015 at a much lower price.

If you're a wealthy investor you'd discuss this strategy with the best financial adviser you could afford. He or she would probably remind you that on top of your "instant dividend" you'll start collecting quarterly dividends on your shares of CY beginning July 18.

Hold your shares of CY for at least a year and your total income from this transaction (12.86% plus 4%) would amount to the equivalence of receiving a 16.86% dividend.

Now that looks like a wealthy return-on-investment for an investor of even modest means. This is an example of a reasonable trade-off between risk and reward for the money invested.

Investing like a wealthy person involves getting good advice and developing a strategy that involves due diligence, exceptional patience, less trading and less portfolio turnover. You'll want to mainly invest in companies that are leaders in their sector and where the insiders (corporate officers) are heavily invested with you.

By the way, the co-founder and CEO of Cypress Semiconductor, Dr. T.J. Rodgers, owned 8,366,493 shares of CY as of the end of 2012. Based on the closing price of CY on Friday, that mean Dr. Rodgers owns almost $940 million worth of the company he leads.

That's another characteristic of extremely wealthy investors. They invest in themselves and they're willing to invest heavily in what they believe in. So why don't we follow their examples in one way or another?

Be patient, be disciplined and follow the wisdom that time and experience will give you. In the meantime, chose your mentors and financial advisers very carefully and know their investment prowess as well as you can.

At the time of publication the author was long CY.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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