A New York times article with Jay Bean the founder of an online marketing firm OrangeSoda caught my eye this week not only because I agreed with his observation that Groupon made a huge mistake in not taking the $6 Billion Google offer ( mark my words Groupon will lose out to Living Social), but because he inadvertently provided a great insight into trading.
Prior to his successful launch of the OrangeSoda agency, Mr. Bean decided he wanted to take a break from software business and run a true retail operation. In 2005 he started a company called Sunglasses Only. Initially he planned an online business, but sunglass manufactures would only do business with him only if he had a retail location. He made his first mistake and compromised. Instead of just walking away, he modified his business plan and decided to open up two large storefronts in order to acquire the sunglasses brands he needed.
When we are trading we often find ourselves in the same position. Sometimes our trading strategy does not quite set up, but in order to participate we often compromise and jump into the market just to make the trade. No one is more guilty of this sin that I, who loves the action sometimes more than winning. But in fact if you want to be a long term winner, you should never compromise with the market. As speculators we have one incredibly powerful choice at our disposal -- we can stand down when conditions are not optimal. However, we often delude ourselves into believing that we will be smart enough, fast enough, accurate enough to violate our well worn rules and still walk away with a profit. Of course that is the biggest sucker bet of them all
In the end Mr. Bean was stuck with an inventory of 3,000 sunglasses that he had to liquidate at a massive loss when the financial crisis of 2008 killed demand for the product by 90%. Apparently sunglasses were not the first thing on consumer’s minds in the post-Lehman environment. Jay Bean said that the biggest reason for his failure was holding all that dead inventory. The sunglasses business would have been viable if he wasn’t saddled with so much unwanted stock.
Although as traders we rarely view ourselves as small storefront owners -- we should. Our business has much more in common with Mr. Bean’s than we imagine, and the issue of dead inventory is key. What is a losing position but dead inventory? Imagine if a trade was a carton of sunglasses. Would we continue to buy more and more sunglasses if the current product was not moving off the floor? As business owners we find such behavior absurd, but as traders we do it all the time when we continuously average down into a losing position in hopes of a small rebound that would put us back in black.
Granted prices in financial markets are far more volatile than in the real markets and reversion to the mean works just often enough to entice us into executing this strategy. However in the end, stockpiling losing positions just as stockpiling unwanted merchandise is a bad strategy that always end in tears. So next time the impulse strikes you to average down, ask yourself -- am I about to acquire some dead inventory?