The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

26 November 2009

Always expect the unexpected

Non-recognitionRecognition Opportunity
Investing in the markets is rarely easy, and often fraught with financial peril; thus, assessments of risk and opportunity must be made, and appropriate action taken. And when the financial markets have trended mono-directionally for too long, and success occurs too readily, an especially suitable moment to pay particular attention is at hand. "Always expect the markets to do the unexpected."

The secret to successful investing is a function of knowing when to exit a position in order to keep the expectancy as high as possible, the amount an investor can expect to make on average over many trades per dollar risked. And to know how large a position to assume to meet objectives, coupled with the discipline to follow these tenets. (Most investors have no set objectives, leave alone any defined money management plan.)

While some scoff at basing one’s investment decisions on past price (chart) action, the shrewd investor recognizes that to follow an investment methodology asymmetrically, or one-sidedly, is akin to having no methodology. To invest based solely on fundamental analysis ignores the medium to transact the purchase, the market, whereas to purchase shares based solely upon technical analysis ignores the fact that the investor purchases shares in a company. It is the foundation of growing sales and earnings that builds a successful company and investment. To conflate this notion, the investor who performs only fundamental analysis would sell his investment based solely upon changes in the company’s fundamental dynamics. The investor who performs only technical analysis would sell his investment based solely upon how the company’s shares trade, and ignore changes in company fundamentals. To take this idea even further, the investor who performs technical analysis only and who purchases weakness will, in turn, sell strength. If he instead purchases strength (or breakouts), then he would sell chart weakness (or breakdowns). To obey each correctly identified signal (or alert) helps assure the investor of the potential for consistent success.

Too, the investor must learn to question each decision, especially his erstwhile decision to buy without its complement, when to sell. “Why purchase this company’s shares over another?” is a good initial question; better would be, “Why do I purchase this company’s shares? What is my objective?” The first question is generated by external factors, the market, and is not as important as the second, which is generated by internal factors, us. This is a notable difference that speaks to why investors assume risk. After all, for whom does the investor invest?

Further, consistent success requires the trader or investor to take his work seriously. Competing interests – career, family, etc – generates the incapacity to pay the necessary attention to a field of endeavor that requires no less. Investing is a business of numbers and psychology, not economics. The successful investor must live the numbers and practice the psychology. Legendary bond trader, Charlie DiFrancesca, believed the best discipline for tyro investors was spreading — taking long positions in one contract against short positions in another, to exploit changes in relative prices. Once the trader was fairly consistently profitable in this low-margin methodology, he would likely succeed at the trickier methodology of scalping — taking positions in one contract to catch waves of price motion. Perhaps without realizing it, scalping is what most investors do but without the added rigors the spreader’s discipline offers. This failure of discipline results in the investor’s inability to transact the other half of the trade: to sell, whether for a profit or to prevent a small loss from becoming a large loss. Human nature causes people to deny their mistakes. We become loyal and hang on too long to losing investments. It is difficult to resist the lure of too quickly taking profits.

Such traders or investors will transact, in general, one or the other of two methodologies, mechanical or intuitive. The mechanical style is for those investors who lack study time, desire, and a firm hold on his or her emotions. The successful mechanical trader accepts the recognition that this method is a compromise between eliminating the poorest trades and retaining the best trades. The intuitive style is for those investors who have a plenitude of study time, desire, and emotional control. Zen and the Art of Investing would characterize this method. The successful intuitive investor will trade what he or she sees, not thinks; patient and disciplined, willing to wait for the excellent opportunity and to ignore marginal opportunities. This investor does not trade for excitement, or to fulfill any element missing from his or her personal life. If the sole lesson the investor gleans when reading this passage is that he or she is unwilling or unable to devote the time and effort to generate consistent success, and this recognition includes the idea that said investor prefers to purchase shares only during uptrends in periods when the market is itself trending higher... well, this is not a deficiency but a strength. To invest outside of this core recognition is detrimental to the investor’s other efforts.

In general, there are two types of investor: those who sell volatility, in essence, a bet that prices would not move much (small profits times large bet size, thus requiring markets with huge amounts of liquidity), and those who buy volatility, or axiomatically, “The trend is your friend.” These investors expect to overwhelm frequent small losses with less frequent but larger profits, and could not care less about macro- and micro-economic factors. They presume all such factors as “already priced in” and hedge the potential for surprises via stop loss orders, etc. To stay safe, investors should always know in advance when and why he or she will exit an investment to preserve capital, and have enough self-discipline to follow through on this notion. If the investor rigorously applies this, then he will no longer fear the market and its oscillation, and recognize that those oscillations are what create the potential for consistent profits.

Knowing what you don’t know
Some investors will learn about the details of what they do through years of experience, but for many a lack of knowledge can be a primary cause for taking large losses early on. Without the necessary capital to sustain through these times, most investors’ career is finished as soon as it begins. These investors not only take losses because they lack specific technical knowledge or understanding, but also because his or her lack of knowledge impacts their psychology. Successful traders argue that even though the tyro investor might lack some information, he or she can still prevent losses if they have the right mental approach, a solid investing plan, and can respond quickly and effectively to changing dynamics. Of course, it's not really possible to know everything, but if a successful investor considers something as "basic," then that basic knowledge is necessary to know. The investor must get to a point where he is sufficiently confident in his knowledge that he can successfully invest, even though he lacks superior knowledge. When inexperienced traders are told this, they often ask, "But if you don't have the knowledge, how can it affect your psychology?" They overlook the fact that you know that you don't know. And consequently, it is their lack of knowledge that directly impacts the confidence in their abilities.

Trading Psychology
The investor’s biggest enemy is himself. Success comes when the investor learns to control his emotions. Excitement (and fear of missing an opportunity) often persuades investors to enter the market before it is safe to do so; exercise caution. After a downtrend, a number of rallies may fail before one eventually carries through. Likewise, the emotional high of a profitable trade may blind us to signs that the extant trend is reversing. Wait for the right market conditions before investing. Exercise patience. There are times when it is wise to stay out of the market and observe from the sidelines. Remain emotionally detached from the market. Avoid getting caught up in the short-term excitement. Screen-watching is a tell-tale sign: to continually check prices or stare at charts for hours is a sign that you are unsure of your strategy and are likely to suffer losses. Concentrate on the technical aspects rather than the money; if the investments are technically correct, then the profits will follow. Focus on the longer time frames and do not try to catch every short-term fluctuation. The most profitable trades are in catching the large trends. Investing involves dealing with probabilities, not certainties. Always expect the unexpected. No one can predict the market correctly every time. Use stop-losses to protect portfolio funds, and act immediately when the stop loss is triggered; don't hesitate.

It is perhaps the quality of patience that separates the successful investor from the unsuccessful investor. Able to "watch and wait" for market generated signals, this investor then aligns his interests with the market’s trends; i.e., the investor listens to the market for the proper signal to get in, get out, move a stop, close a position, stand aside, or wait for a better opportunity. Time and again, the market provides invaluable clues and signals. Judgment and results will suffer the moment the investor decides he knows more than the market, and throws aside patience, giving in to fear or hope. Exercising patience requires that investors recognize they cannot fight the market’s major trend, irrespective of how exciting the opportunity seems. Success requires following the prevailing major trend, waiting until a new trend develops. Most important, the successful investor will not trade or invest when he does not understand the market. When in doubt, do without.

Bases manifest as repeated testing, or backing and filling — until the buyers get the upper hand, and the share price breaks above resistance. Or vice-versa. As a chart pattern builds via adding each new trading day’s price bar, one would expect declines to test the bull’s thesis… and resolve. It is here that the observant investor discovers that the notion of ‘support’ is commonly misperceived. In fact, support works primarily within a rising trend and resistance works primarily within a declining trend. Hence, for a true change in trend direction, the patient investor will seek this new dynamic: after a lengthy decline, new short-term price declines halt at identifiable intermediate and long term price support, aborting continued weakness (new lows). Contra, after a lengthy advance, fresh short-term price rallies encounter resistance to continued strength (new highs). Remember to identify and align both the markets’ trends and your time horizon.

The realities of investing
There is no person, committee, indicator, wave count, or Holy Grail that can consistently and accurately predict tops and bottoms in any market. Over the long run, the knowledge and understanding that there are no predictions only probabilities will be much more useful than a thousand forecasts. Too, losing trades are a natural part of trading, just as losing investments are a natural result of investing. Realizing these losses is a positive step because it allows the investor to consistently limit his losses to a manageable amount, if the investor gives short shrift to losing trades. This allows him to return the next day with capital and no pre-disposed emotional bias. Keeping individual losses to a minimum helps prevent a losing streak from overtaking both the investor’s portfolio and emotions. 

The Path to the Plan
To avoid this from occurring, the investor must have a plan. Most traders understand that it's critical to have a solid trading plan that works in collaboration with their trading personality and is completely their own. What many traders don't understand is how to actually do this. How do you create an effective trading plan and how do you use it? Unfortunately, there is no step-by step process to follow. Based on their strengths, most investors will incorporate analysis methods they are naturally good at. And for their weaknesses, they will develop their plan to include safeguards against those weaknesses. This plan would serve as a road map. This mean the investor knows before he enters a position why and when he would exit that position, which helps to remove the investor’s emotional biases, especially to unforeseen events. To perform less would help usher in portfolio failure.

Answers the following questions, otherwise investing is tantamount buying on hope.
• Which markets to trade/invest?
• What criteria to use to enter a trade/investment?
• What criteria to use to exit a trade/investment with a profit?
• What criteria to use to exit a trade/investment with a loss?
• How much capital to risk per trade/investment?
• How much margin to use, if any?

Most investors primary concern is, “What is my expected gain?" rather than “What is my possible loss?” If the possible loss is half the portfolio’s value, two consecutive bad trades wipe out the investor. The larger the portfolio value, the worse the dollar impact a given percentage decline will have on portfolio equity. Too, it requires a far greater percentage gain to make up for a given percentage loss; for example, a 100% gain is required to amend a 50% decline. More onerous is the portfolio that, after having scored three consecutive annual gains of 20%, suffers a loss of 45% that serves to reduce the portfolio equity to less than the starting amount. To keep losses contained at small amounts is therefore critical for consistent success.

To decrease the dollar amount of risk per position, the investor has four choices:
1. Close (or never open) the position;
2. Sell part of the position or take a smaller initial position;
3. Move up the stop until the dollar risk is reduced to an acceptable level;
4. Purchase the position as close as possible to the stop point.

While it is true that many investors do not plan to fail they do fail to plan. The absence of a good risk control plan is perhaps the primary reason that most tyro investors grow discouraged, give up, watch hard earned profits dwindle away, or crash & burn. To view each investment as a working hypothesis is a worthy start. Too, does there exist an optimal position size, expressed in percent, for all portfolios? For example, should the investor’s portfolio consist of five 20% positions, ten 10% positions, or twenty 5% positions...? How does the investor make that decision? Does holding too many positions promote over-diversification? Some studies suggest that there is a limit to the benefits of diversification, with the best effects of diversification best offered at ~9 companies; more, and the investor’s insights are diluted, less, and the portfolio remains tied to the market’s yoke. Of course, this begs the question of diversifying across assets. Nobel Prize winner Harry Markowitz demonstrated that holding a portfolio of assets with high standard deviations but inverse correlations (when one rises the other declines) could lead to a higher rate of return with a lower aggregate standard deviation. This disproved the widely accepted idea that increased return comes only with increased risk; that an asset by itself appears risky might paradoxically reduce a portfolio’s risk. For example, within any asset class, to hold several positions is less risky than to hold an equal dollar value of just one.

To diversify beyond the number of portfolio investments would include diversifying across systems, or developing core competencies in various market patterns and setups, or oscillators, or to make price action conform to investors’ sentiment, even the passage of time. Critical diversification is also offered by the type of investment: insurance or annuities, real estate, precious metals, and alternate currencies.

What to do when things go wrong
Take action! Do not hesitate, do not belabor the matter, do not grieve, do not shift responsibility, and do not hope. The market has sent a signal that the wise investor either heeds for his benefit or ignores at his cost.

To exercise the proper level of patience, the investor must await the market’s signal, and only then does he invest in the specific opportunity that beckons him. For example, when looking for an entry level to purchase in a down trending market, always purchase as near as possible to critical, major, and correctly identified support. Correctly identified does not necessarily mean that the position will work out as projected or preferred. Investing is about probabilities, not certainty. Was the line of support correctly identified, or would some other price level have been more correct?

I accept, as an investor, the likelihood of (small) loss -- but only as the entry ticket to make sizable returns.
-- David M Gordon / The Deipnosophist

PS: Please visit Investment Poetry for specific investment opportunities, price and timing included.


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