The Vigilant Investor - A Review

Back in 1999 and 2000, I participated in an online chat room dedicated to technology and technology stocks. It was a boom time for these companies, and the ease with which their investment recommendations and suggestions rose in price made participants feel empowered. "Who needs Wall Street?," they argued. Analysts were disparaged as "analists" and Wall St excoriated for its clueless and bumbling nature.

"Empowered," they claimed; I argued otherwise. Investing done with no due diligence raises Damocles' sword over their (and your) untested, unseasoned portfolios. My efforts were futile; the party in full swing. We all know what happened next.

"Due diligence" is a term used often; unfortunately, it means different things to different people. I argue that due diligence performed by and for investors is not bound by what and when to buy, but should you buy. And under what conditions should you sell? You must know, in advance, why you bought what you own, else run the risk of a market's wrath (aka, a bear market) - wondering suddenly whether you should buy (more), hold, or sell. (And flee as fast as possible.)

Pat Huddleston is an attorney, former Enforcement Branch Chief for the SEC, and founder/CEO of Investor's Watchdog, a company that conducts fraud investigations for pension funds, endowments, family offices, and individual investors. And now author of the new book, The Vigilant Investor

Pat adds a deeper layer of meaning and intent to the term, due diligence: to protect your portfolio, your life's savings, and you from investment scams and scammers, and even yourself. In story after story, Pat discusses the cons and tricks of which you should be wary, the typical profile of the con artists (they share similar lifestyles and types), and how your own sensibilities and personality helps make you susceptible; prey to their predatory nature. Pat states unequivocally,

"I know how scams and unethical advisers begin, how they operate, what contributes to their longevity, and what tactics they use to ensnare individual and institutional investors alike.”

In one story after another, Pat tells - often with colorful prose rich in its clever use of analogies, metaphors, and similes - of how investors have been bilked of their savings, how they continue to be bilked, and likely will be bilked into perpetuity. I am reminded of an aphorism from the 1970s re limited partnerships, "At inception, the general partner has the vision, the limited partners the money; at the end, the general partner has the money, the limited partners the vision."

Not on Pat's watch, though. After each chapter, he provides checklists that help the reader and investor avoid the emotional weaknesses or scams Pat discusses in the prior pages. And, at book's closing, Pat even suggests creating and fostering associations (or networks) of vigilant investors (AVIs, in Pat's abbreviation) that could communicate and inform each other; an InterPol of sorts but of/for/by investors.

Until then, Pat shares many lessons applicable for all investors:
* Trust, sure, but always verify, verify, verify. And verify the verifiers!
* Steer well clear of charlatanry.
* Watch out for conflicts of interest.
* Do not chase return or yield.
* Create a paper trail of all communication, complaints included.
* Learn that high pressure sales tactics are near synonymous with guaranteed loss of principal. (And principles.)
* And many, many more such facts and hints to avoid scamsters.

Your increasing portfolio value has you feeling empowered? Never forget the process of due diligence: why you buy what you buy, when you buy it, who sells it to you, and why they sell it. (If the investment's destiny is for an increased value, then why sell it now, to you...?)

Pat Huddleston's, The Vigilant Investor, belongs in the libraries of all investors everywhere. Not just filed away as a reference and resource, but read and read again; pages bookmarked, sections highlighted, the book readily available. Pages 12-16 alone, in which Pat recounts the tale of the "Geritol Gang," are worth the price of admission. Highly recommended.
-- David M Gordon / The Deipnosophist

How Indices Work -- Excellent primer from David Blitzer

How Indices Work

David Blitzer is a managing director and the chairman of the S&P Index Committee with overall responsibility for security selection for S&P’s indices and index analysis and management. Dr. Blitzer is the author of Outpacing the Pros: Using Indices to Beat Wall Street’s Savviest Money Managers (McGraw-Hill, 2001) and What’s the Economy Trying to Tell You? Everyone’s Guide to Understanding and Profiting from the Economy (McGraw-Hill, 1997)

Q: Let's start by talking about how the S&P 500 is composed.

A: It is 500 companies. We occasionally get phone calls, believe it or not, about how many stocks in the S&P 500. It's overseen and maintained by a committee of nine people, all of whom work for Standard & Poor's and McGraw Hill, our parent company.

We have a series of published guidelines and requirements for a company to be added to the Index. It has to be a US company worth at least $3.5 billion dollars, trade with adequate liquidity, have at least half the stock available in public float.

We look at what sector or industry it belongs to, to keep the balance of sectors in the Index very close to the balance in the market. And last, but certainly not least, it has to have made money. It has to have four quarters of positive earning using generally accepted accounting principles (GAAP) net income.

Over the years that has proven to be surprisingly important to the whole process.

What happens when someone reads that the S&P is up 10 points or down 10 points. How is that calculated?

The Index is what we call a value-weighted index, or sometimes called market-cap or market capitalization-weighted index. You take the market value of each company in the Index, and you add it all together, and you will get a number that is probably about $9 trillion right now.

Well, $9 trillion is sort of a big number to report every 15 seconds. In fact, by the time you get to the end of the number you've used your 15 seconds.

We divide it by a scaling factor called the divisor, and that gives you the value of the Index, 1,142 or whatever it happens to be. When you say the index is up, you take the value of all those companies – some go up, some go down at any given moment – the ones that went up outweigh the ones that went down, and after you scale it to a number that’s easy to handle, you come out with say 10 points, and maybe the Index has moved from 1,140 to 1,150.

You say that the companies are market weighted. What would be the biggest company in the Index right now, the most important company today?

The biggest one is most likely Exxon Mobile which is a giant US or global oil company.

So you have a company like Exxon at the top of the list, and they are up 3% in a day, and then you have one at the bottom of the list not nearly as important, and they are down 3%. So you've got two members, one’s up, one’s down, but they are not of equal importance to the index as a whole?

That's right. Let's assume the other 498 stocks didn't move, just to make it simple. Exxon mobile goes up 3%, and the number 500th company goes down 3%. The Index overall will be up, because Exxon Mobil's weight in the Index is going to be much larger. Its weight is probably 3, 3.5, or maybe 4%. The one at the bottom we’re talking about is a very small fraction of a percentage point.

You mentioned the S&P is the most widely followed the Index, but probably not the best known. The best known would probably still be the Dow Jones. Can we talk a little bit about how the Dow Jones differs from the S&P 500?

There are two big ways. The obvious one is the Dow has 30 stocks. We have 500. Quantity is not the answer, but with 500 stocks one gets much broader coverage of the overall market. And you know, you cover more, you're more likely to include stocks that either went way up, or way down, or did something else somewhat unusual.

The other way is the calculation. The Dow uses the same calculation method that they started using in 1896 when they did this on the back of an envelope, probably with a pencil and paper. They take the prices of the 30 stocks – not the value, but just the price – and they add up the number, and then they divide by a scale factor which gets them to their number.

So you can have two companies in the Dow, one may be worth 10 times the other one, but a one point rise in either company will have the exact same impact on the Index.

The other thing about the Dow, just because the way the arithmetic works out, is the number they divide by turns out to be very small. It's actually a little less than 1/5. So a one point move in the Dow by a stock, any stock, will be a five point move in that Index.

Or maybe more to the point, if 10 of the Dow stocks do nothing, and the other 20 each go up say two points, those 40 points are going to echo into a 200 point move in the Dow Jones. And a 200 point move in almost any Index is going to hit the news wires in a big way, and get people probably more excited than they really should be.

The Dow is equally weighted, unlike the S&P which is weighted by the actual market value of the company. Let's suppose a stock in the Dow has a price of $150, and another one with a price of $15, and you have a two dollar movement in each of those, does that two dollars have a different impact on the Dow overall?

Yes. If the $150 stock went to $152 which is a tiny little fraction of a percentage, and the other stock at $15 went to $17, this is a big move in percentage terms. Those two moves have the exact same impact on the Dow. Two points on the stock would be about 10 points in the Dow.

So you're getting movements that just depend on whether a stock is priced at $15 or $150, which really has nothing to do with the underlying value of the company.

Whereas in the S&P 500, it’s how much the value of the company has moved that determines the impact on the Index, and that's one of the reasons why we believe that market weighting gives you a much better door to understanding what's going on in the stock market. A big reason to follow indices is to understand what's happening in the stock market overall.

Some of the media coverage you hear occasionally says that we should buy a company, because it might be added to the Index. So could we talk a little bit about the underlying thinking to that?

Look at the S&P 500 and the amount of money that’s managed to track the Index, in exchange trade of funds, Index funds, pension funds, and other institutions whose investment strategy is to replicate the Index.

If a stock is added to the Index or taken off it, do they have to replicate that change?

That's right. They have a commitment to replicate the Index. The totality of that money is something well over a trillion dollars. If you go through the arithmetic of what that means, then for any stock in the Index, about 10% of the outstanding shares are going to be held by this collection of Index replicators.

So if we add a stock to the Index, and let's assume for a moment it's not in any other Index we run at the present time, over a period of a week between when we announce it is going in and when it actually goes in (because we make announcements five trading days in advance), about 10% of the stock is going to get bought up.

It has to happen. This is a very large buyback program. To give you some frame of reference, a corporation running a buyback program buying back its own stock will buy back a half percent to 1% of the outstanding shares in a quarter of a year, 13 weeks.

So these replicators are doing 10% in a week versus 1% in 13 weeks. The stock goes up. Typically it will gain 5, 6 or 7% over a week maybe two-week period. It will gradually give that back over the next three to six months, so this is not a permanent all-time rise, although it is very exciting. If you knew in advance what we were going to do, and we play this very, very close to the vest for obvious reasons, and you traded options, it would be even more exciting, but it would probably be trading on inside information unless it was just a lucky guess.

That's the case when you add a stock to the Index, just buying pressure from institutions and ETFs forces the price up short-term. Does the same apply when you take a stock off the Index that the price gets pressed down?

It does, but it’s much harder to calculate. The data are much thinner for a couple reasons.

First of all, something like two thirds of the exits from the Index are caused by M&A activity. So the stock that's coming out and being acquired in a merger, the price is predetermined by the terms of that merger.

And has already been pushed up?

It's already had its run up at the very beginning of the transaction process. There are other cases where when we take it out because it has fallen on very, very hard times. It clearly no longer makes any sense in the Index, and the selling happened months ago, not right now.

So while there probably is a short-term decline in a stock when it comes out, it’s much, much harder to measure and gauge. There are much less data. There are a lot of special circumstances that would be very hard to disentangle.

If someone is online and they see that you've just announced that you are adding a stock to the Index, should they rush to their broker to buy it?

First of all, we make our announcements at 5:15 PM Eastern time so the markets are officially closed. These days you can trade anything, anytime, anywhere, but the markets are very thin when it comes to 5:30, 6:00, or 6:30 in the evening. So it would be a little bit dicey to do that. But more so, this is a short-term play, and if you are into fast and furious short-term trading, you place your bets and take your chances.

If you're a long-term investor, and if you look at the long-term history of the US stock market and indeed of most developed stock markets, they have sideways periods. They have sustained periods where they don't seem to advance, and we are unfortunately in one, though hopefully coming to the end of one.

But over the long haul, markets do very well. As a long-term investor, the strategy to replicate an Index turns out to be very successful, in large part because it’s incredibly cheap.

I want to talk about some of the sectors in the S&P, where they've been in the past, and where they are today. Let’s start with the financial sector. What's the average importance over time for the financial sector in the US stock market?

The average importance has probably grown over the long term over the last three or four decades. Currently it's in the high teens. At its peak it was probably 20 to 25%, in roughly 2007. Clearly it came down very sharply with the financial crisis, as a huge number of large banks cut their dividends and a couple of very large public companies literally disappeared.

But what surprises many people is that the past decade, from the market bottom in 2002 to the peak in 2007, while financials are very important, they weren't incredibly dominant. It was not a financial repeat of the Tech boom. It was a broad-based improvement in the market over those five or six years.

Talking about the Tech boom, where did the Tech sector peak in terms of its importance in the US stock market?

The Tech sector was almost a once in history event. If you go back to about 1994 when it started, technology was around 8% of the Index. At its peak it was probably a third, 30 to 35% of the Index.

Today it's down to 15 or 16%. It's been moving up lately, and doing somewhat better. Probably in the long-term it will have a strong position. I'm not sure it will get back to the one-third level though.

One of the debates when it comes to investing is value versus growth. Those tend to be the two alternative approaches. What does your track record show in terms of the investor experience using a value approach versus a growth approach over the long term?

Over the long term, value tends to outperform, not year-by-year by any means, but over the long sweep of time. Value builds and maintains what appears to be a sustainable lead on a totally long-term basis. Value stocks tend to have higher dividends and are more likely to have dividends than growth stocks, and that's a big part of their long-term benefit.

But really the only time that growth seemed to suddenly surge ahead briefly was at the very end of the 1990s. At the peak of the technology boom, growth stocks were heavily dominating technology and appeared to be unstoppable. We know as a result of what happened shortly after the beginning of 2000, they were stoppable.

You mentioned dividends just a moment ago. Can you point to long-term data in terms of the investor experience focusing on companies that pay dividends compared to those that don't?

Yes. We put together a list a number of years ago which we continue to maintain, and what we nicknamed Dividend Aristocrats. These are companies in the S&P 500 with a record of at least 25 years of increasing their cash payout to investors.

So not only were they paying dividends or maintaining their dividends year-by-year, they were actually increasing their payout. There are not too many of them, and we've lost a lot in the last few years to other issues, but over the long term on a total-return basis, these stocks do very nicely.

Last fall I had a chance to interview Jeremy Siegel at Wharton. In his most recent book, Why the Tried and the True Beats the Bold and the New, one of his suggestions was that new companies get added to the Index after they've had the best period of their run-up, and investors actually are often not served by buying companies after they are added to the Index. What is your perspective on that?

Two things stand out, one particularly regarding Jeremy Siegel and his research.

He did some work a few years back for which we provided a lot of the background data, looking at the companies that were in the S&P 500 in March of 1957. This was when the Index moved from being 90 stocks, as it had been in ancient days, to being 500 stocks as it is now.

He studied how those companies did. His argument was that the original 500 actually outperform some of the ones that went in and out of the Index. There were a lot of particular stories in that period of time. So I'm not sure it's a general result, but it was a fascinating piece of work.

More to the focus of investors today, the S&P 500 is the large-cap stocks at the top of the market. Below that in size is a mid-cap Index of 400 stocks, and below that is a small-cap Index of 600 stocks.

The small-caps tend to be very exciting. There are some wonderful stocks there. There are some less wonderful stocks. They’re a little more volatile, and because they are small they are a little bit riskier typically.

The 500, as Jeremy Siegel suggests, are solid long-term good ideas, but they may have passed some of their high-speed growth.

Sitting in the middle turns out to be the mid-cap Index, and while obviously the past is no indication of the future, over the long haul since the mid-cap Index was created in the early 1990s, it does seem to have this attractive balance between the more rapid growing, more exciting, more dynamic smaller stocks, and the more secure larger stocks. It seems to get the best of both worlds.

For an investor who listens to Professor Siegel and doesn't want to own just the biggest stocks there are, but wants a little more interest and excitement, I would poke around and look at the mid-cap 400 among other things.

That sounds like an interesting idea, and one I think that many people hadn't thought of. Is there a risk that of that the 400 mid-cap companies you'll get the 20 or so that excel, that really become home runs, and then they grow to the point that they move off the mid-cap Index onto the 500? So will investors lose the growth once they've met that threshold and are no longer in the mid-cap Index?

Looking at the three indices, a large proportion of the stocks going to the S&P 500 come out of the mid-cap.

The way we maintain the indices, a stock can only be in one Index of the three at a time. It can't be in multiple indices. A company that outperforms or grows faster than most other companies will move up in size, and if it continues to do so, it will move to the top of the mid-cap and it will become a reasonably good candidate to be moved to the 500.

There's certainly no guarantee. Number one in the mid-cap by size is no more likely than number five, or number 10, or number 15, to be moved into the 500, although clearly the top 50 to 100 are probably more likely than the bottom hundred.

The one aspect that makes it very intriguing is the following.

I mentioned earlier that a stock going in the S&P 500 gets a short-term bump up. So let's say we announced tonight at 5:15 that a stock is going to come out of the mid-cap and go into the 500 after the market closes a week from today, which is the typical time frame.

For this week, which is when it gets a lot of that bump, it is in the mid-cap Index. It is not in the 500. At the end of this week it will get moved into the 500. So if you were sitting on the mid-cap, you got the bump. It goes into the 500, and over the next two, three, or six months it gradually drifts down and gives back what we're calling an “artificial bump.” It's already in the S&P 500, which is another reason why the mid-cap might be an interesting thing to take a look at.

Apple, Steve Jobs, and the French Revolution

Haughty attitudes and high-handed treatment of customers can go only so far before the peasants revolt. Although likely apocryphal, Marie Antoinette's phrase, "Let them eat cake" inspired a revolution... and a few beheadings. Tetchy people; testy times.

Seems the zeitgeist today is not much different. And when the much revered Apple Inc rushes to market its faulty iPhone 4G, and its users and customers complain complain complain, and complaints home in on its bad antenna, Steve Jobs notoriously says, "Let them eat cake." Er, actually Consumer Reports helps Steve realize he means, 'Let them have duct tape!' (At least it rhymes.) I can see how Steve was confused.

But this new news that Apple Inc is thin-skinned? I, mean, c'mon! Even Microsoft, in its heyday as the Evil Empire, never stooped this low.

And let's not mention the entire Gawker episode in which Apple had the police bust in the apartment door of the journalist who had the pre-release version of the iPhone 4G. Whoa, chill out, guys. You're becoming Appholes, in Jon Stewart's memorable term. You run the peril of fomenting a riot against... yourself.
-- David M Gordon / The Deipnosophist

How Professionals Select Investments

So here's an odd descriptor: the excellent article below is both lengthy and yet pithy. The important item for all investors is that it provides plenty of fodder for thought via its many insights re investing.

Makes for excellent homework.
-- David M Gordon / The Deipnosophist
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How Professionals Select Investments
By Adam Jared Apt, CFA

As we’ve pursued our errand of increasing wealth, we have been stalking a magical prey.  We have scrupulously observed it, and we’ve seen that the creatures that we’ve been stalking, that is, investments, have two essential but mutable attributes: the prospect of sustenance (return) and danger (risk).  Even when we have captured our prey (selected our investments), these attributes persist, with our captive investments’ returns continuing to evanesce until, finally, we devour these creatures, that is, spend the wealth. Only in consuming them do we really, definitively, know what sustenance they could provide.


In considering the attributes of return and risk, however, we have neglected another attribute of our prey.  Investments are social animals and interact with each other in complex ways that will determine our wealth even after we have corralled them. The return and risk of an assemblage of investments are determined as much by their interactions as by the returns and risks of the individual investments.

I have not, so far, introduced you to strategies for capturing our prey. Whatever tactics we choose, our strategy will have two essential components: first, the selection of particular investments, and, second, a plan to take advantage of their social behavior by combining them best to serve our interests.

We refer to these components of an investment strategy as security selection and portfolio construction.

Most investment writing for the public is about the thrill of the hunt, that is, security selection. It is all about tactics, with little regard to strategy. Some writers try to convey the excitement of stalking the biggest and most elusive returns, sometimes with regard to the dangers, sometimes not. Other writers may feel the excitement, but only ploddingly lay down routine procedures that they advise you to follow. A few popular investment writers address portfolio construction, but such literature looks pallid beside writing about chasing the investments that seem to offer the most gorgeous returns.

In contrast, I have chosen a more considered, reasoned approach to investing, observing and analyzing first, before developing a strategy and tactics based upon what we have learned. To a degree, this contrast corresponds to the (rather simplistic) division I cited in my article on return and risk, between the “sportsmen” and the “academics” of investing.

Security selection

Anyone can select securities. How many times have you heard something like, “Apple is a great company and a great stock;” or, “Citibank stock has been beaten down so far that now it’s a good bet to go up,” or, alternatively, “Stocks can’t keep going up like this”? To select securities thoughtfully, however, requires an extensive education, either through home schooling or in the classroom, and there are many textbooks to teach you. Like all worthwhile endeavors, security selection requires hours of study and tedium. You have to learn accounting and mathematics and statistics and economics, and various intellectual tools and techniques. I will only outline how serious investors go about it, not teach you how to do it.

By “securities,” I mean stocks, bonds, shares in mutual funds, exchange-traded funds, and more abstruse investment vehicles, and also entire asset classes and sub-classes. That may be stretching the definition of “securities,” but it still fits if we’re talking about deciding which things to put into a portfolio.

“Security selection” is a broader term than “security valuation,” an expression with which it is often conflated. I, personally, would wish them to mean the same thing, but they don’t, because securities are often chosen, not because of their value, but because of their behavior.

There are, broadly speaking, two approaches to security selection: tactics based on valuing securities and comparing their values to their prices, and tactics based upon the behavior of the prices of the securities. The general terms that we professionals use for these two kinds of tactics are fundamentaland technical analysis.1 Fundamental analysis is pretty much the same thing as security valuation. But don’t let the word “technical” confuse you. In this context, it doesn’t imply scientific methods. Technical analysis is the use of series of past prices (or quantities of shares traded, called “volume”) to predict where prices will go, without reference to accounting values and economic analysis. One very common way of pursuing technical analysis is called charting, because it relies upon charts of prices. Some speakers use “charting” and “technical analysis” interchangeably.

Fundamental analysis

Security valuation is necessary when an investment vehicle is not traded in the open market. If it’s not traded, then the public market hasn’t set its price. Such an investment might be, for example, a venture capital stake in a startup company. But very commonly, security valuation is undertaken for even publicly-traded securities because of two underlying assumptions: first, that the value of a security can be different from its price, and second, that if price and value are different, then the market will discover its mistake, and it will reasonably swiftly correct the price toward the true value of the security.

You might think that both these assumptions should go without saying. But according to the controversial theory of efficient markets, prices almost always match true values, and if they don’t, still, anyone’s chances of correctly identifying mis-valued securities are no better than they would be if he picked securities at random. This theory is not as outrageous as it is often made out to be (especially by those who don’t understand it), but it has a crucial limitation. I will discuss it in a later article. If we accept that the market misprices securities, then we must hope that the market sooner or later—and preferably sooner—recognizes correct valuations. It does you no good to be right about the value of a mispriced security if the market obstinately persists in being wrong.

It’s critically important always to bear in mind that when we’re considering publicly traded investments, the price is known. The value (or as we sometimes say, the intrinsic value) is an inference.2


Some investment analysts who analyze stocks would at this point interject that they try to identify not just undervalued companies, but the stocks of companies that are likely to grow rapidly. I wouldn’t quarrel with them, but there’s an ambiguity in the way that investment professionals and the financial press use the word “undervalued” and similar words with “value” in them. As I and some others prefer to use the word, valuation takes into account the prospects for growth.

As I stated in my article entitled, “How to Think about Return and Risk at the Same Time (Part I)”:

Everything comes down to the ability of an investment to generate cash now and in the future, because cash gives you the ability to buy stuff.

So, at least in principle, when you value an investment, you want to know how much cash it is generating or could generate now, and how much cash it will or could generate in the future. Implicit in this description is whatever growth there might be in the investment’s ability to generate cash.

Different kinds of investments require different kinds of fundamental analysis. The analysis of bonds, for example, requires consideration of basically two things: the chances of default (that is, that the issuer won’t be able to make the contractual payments that a bond represents), and interest rates. The evaluation of stocks, to choose the other prominent example, requires those considerations and much more. The valuation of commodities requires entirely different kinds of knowledge, having a bearing on resources available, demand (which depends on the overall economy), costs of extraction from the earth and transformation into a form that can be consumed, and so forth. Valuation of entire asset classes as a whole requires broad judgments about the overall economy, including the world economy.

In principle, we know how to go about fundamental analysis. But it’s difficult to apply in practice what makes sense in principle. Think about your own household budget: If you earn a regular salary and your bonus, if any, is small, and your family’s circumstances are fairly stable, you could project your net of income and expenses reasonably well out for, say, five years, assuming no disasters or windfall from the estate of a rich uncle. Care to make a longer-term projection? Now think how difficult this is for, say, a complex corporation whose revenues are at the mercy of a complex economy. Or for a government that has issued bonds.

Let’s focus on stocks. Rather than simply calculating cash flows each year out into the indefinite future, fundamental analysts of stocks necessarily use a congeries of methods and rules of thumb and imagined economic scenarios to value a company. Sure, they usually begin by calculating how much cash the company currently has on hand and can generate, but they have to determine how much is the result of normal operations, and how much has come from extraordinary occurrences. And they have to judge how often extraordinary occurrences occur. They calculate ratios to make comparisons. They study the competitive situation of the company. They worry about legal liabilities. They judge the character, honesty, and ability of its management. They estimate the demand for its products. Normally, the analysis of the financial statements is just the beginning of the fundamental analysis of a stock.

Many times, it’s also the end. Some analysts have to look at so many companies so quickly that they can’t perform thorough analyses, and therefore use just a few simple measures, like a comparison of the profits (per share of stock) of a company to the price of its stock. The basic idea—and it is this basic—is that if the price is a large multiple of the profits per share, then you’d be paying a lot for what the company earns. And if it’s a very low multiple, then the market may be undervaluing those earnings. Some analysts do this not so much to pan for gold as simply to winnow out companies that are worth deeper scrutiny. Others (generally those who use computerized methods, that is, “quants”) recognize that there is too much uncertainty in the reality underlying those earnings numbers to justify buying, say, the stock of the one company whose price is the lowest multiple of earnings, but reckon that if they buy the stocks of all the companies left in the sieve, the averages will be in their favor. And, interestingly, there’s quite a bit of statistical evidence that this works (at least for a while).
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Although the analysis of financial statements may bring to light companies that are deeply undervalued, it has greater utility in estimating risks. Financial statements may reveal to the perceptive analyst something about very near-term earnings, but they can’t imply much (numerically) about earnings two, three, or more years from now. From honest financial statements, however, the analyst can judge the quality and stability of management and the ability of the company to withstand economic shocks. Risks to a company’s prospects mean there’s risk to the stock as an investment, which then (if it becomes part of your portfolio) is a risk to your wealth. There are so many contingencies in a company’s fortunes that it is very, very difficult to translate the risks faced by a single company into the risks faced by a portfolio. But if the analyst judges a company to be stable and well run, then, after estimating its value using more qualitative considerations and judgments, she may consider it a worthy addition to her portfolio.

Technical analysis

Technical analysis has always struck me as so bizarre that I find it difficult to describe dispassionately. And yet, although I and many others in the investment profession find it nearly impossible to justify, it is commonplace.

Technical analysis attempts to predict the future price of an economic entity, such as a stock, by consideration of its past and present prices (and, sometimes, numbers of shares traded, the trading volume). Its predictive scope is usually but not necessarily short term. Valuation and the estimation of cash flows are entirely outside the scope of technical analysis.
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A basic chart of stock prices, or of market prices, is history. But if you draw inferences about the future from that chart, you are engaging in technical analysis. Any time you see, superimposed on a chart of historical prices, a line representing the moving average of prices, you are looking at an aid to technical analysis. Most of the graphics in the newspaper Investor’s Business Daily are technical charts, intended as aids to prediction.

The language and graphics of technical analysis pervade the financial press. Whenever you hear a daily business report that says that the market had a “correction,” you have heard a technical term. It is saying that the market went down because it had gone up too much, not because any new economic information caused the market’s participants to revalue their holdings. By implication, it is saying that there was noeconomic revaluation of the market. Similarly, one commonly hears of a stock, or the stock market, “testing” new highs, or new lows, or “breaking through” a resistance level, or a support level.

Our ordinary language itself encourages a technical cast of mind: If you say “The price is going up,” you’re saying that you know where it is going, even though you know only where the price has been. (For myself, I am always scrupulous to use the imperfect tense when I say what the market has been doing, not what it isdoing, but hardly anyone I know is so careful.) It’s often difficult to restrain one’s own mind from projecting a graph of data that have accumulated over time, which we (following the statisticians) call time series. For those so inclined, it may not be possible to refrain from seeing familiar patterns in a graph of any time series data, not just prices. I have, indeed, known a technician to infer a projection from a time series of numbers that were neither prices nor anything that anyone else was likely to have observed.

A technician treats a time series of prices as if it were an animate being, as if it had a psychology of its own. And that is their point: Technicians explain that their analyses work because the market has a psychology, and that this is made manifest by the way it moves prices. Here is their official definition of technical analysis:

Technical Analysis is the study of data generated by the action of markets and by the behavior and psychology of market participants and observers. Such study is usually applied to estimating the probabilities for the future course of prices for a market, investment or speculation by interpreting the data in the context of precedent.3

For all its psychological prestidigitation, technical analysis is in no way simple. It is a body of tools and methods designed to recognize and aid the interpretations of patterns, for example, the famous “head-and-shoulders” pattern. There are software packages incorporating complex statistical methods and graphics, many of them sold to amateur investors, that ease the way toward technical analysis. Technicians have their own high-flown jargon. For example, the word “stochastic,” which is ordinarily an adjective that is more or less synonymous with “probabilistic,” is, for technicians, a noun that is short for “stochastic oscillator,” a graphic and numeric method for guessing when the price of a security is going to change direction (up or down).

The most fervid technicians actually argue that fundamental analysis is useless, that only technical analysis can identify investment opportunities. There are legends or myths of technical analysts who work in windowless rooms with only charts and no distraction by actual economic or financial information and news. The more moderate technicians, however, speak in terms of probabilities (though not precise numerical probabilities).

So, on the one hand, fundamental analysis presumes that, while the markets are imperfect, they will sooner or later rationally correct their errors of valuation. Technical analysis, on the other hand, presumes nothing about rational evaluations, but instead is predicated on the belief that changes in price are determined mainly by the emotions of the market.

Within the investment profession as a whole, technical analysis tends to be regarded with skepticism and a degree of shame. The technical analysts know this, and they can be a little tetchy about their work. To lend it respectability, they have institutionalized it. They have a professional organization, the Market Technicians Association (www.mta.org), and a professional qualification, the CMT (Chartered Market Technician), for which the candidate must pass three rigorous examinations. It is telling, however, that the curriculum of study for the CFA (Chartered Financial Analyst) examinations requires only that one be able to describe technical analysis, not actually be capable of doing it.

Many large investment companies, which usually rely upon fundamental analysis, employ a market technician or two. But more broadly, many portfolio managers who would not admit to being technicians themselves will, all the same, consult technical charts and reports, rather as someone who doesn’t quite admit to belief in astrology will nonetheless read his horoscope. They’ll explain that it can be helpful in combination with fundamental analysis.

In my experience of disputation, technicians, like believers in, say, astrology, cannot be disabused of their beliefs through rational argument.4 And like all shamans and magi who must defend their practices in the age of statistical testing, their response to the numerous rigorous debunkings of their methods is that systematic statistical analysis is unable to capture the subtleties of their constantly evolving and adaptive prognostications.

This comparison with astrology can be extended further. One of the arguments employed by those who believe in astrology is the extension by gross extrapolation: We know that the moon influences the earth by creating the tides, and the sun’s position in the sky creates the seasons and influences the weather, so why should not the planets and the stars influence the course of events on earth in a predictable fashion?

Similarly, technicians use analogy as a springboard for a flying leap, rather than as a lamp to illuminate the path to understanding. We know of quite a number of behavioral patterns in the ways that investors make their decisions, they point out, so why shouldn’t we think that these behavioral patterns will be reflected in market prices? But the technicians’ postulations of market psychology are not in any way related to research into behavioral finance, an academic discipline that has grown up in the last few decades.

The reason that technical analysis shouldn’t work, I should hardly have to point out, is that this flies in the face of the idea of the market being a mechanism for valuing the things being traded. A technician would, of course, disagree. One alternative definition of technical analysis that the Market Technicians Association posts on its site says:

There are three premises on which the technical approach is based:

• Market action discounts everything.
Prices move in trends.
• History repeats itself.

It would require a couple of excursuses on the concepts of discounting and market efficiency to explain the fantastic economic implication of combining these propositions. Let it suffice to point out that if the market discounts everything (which is financial language meaning that prices take into consideration all information), then it discounts history, too.5

By this point, you’re probably wondering: But what do I really think about technical analysis?
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Er, well, there may be something to it. But nowhere near as much as the incorrigibly credulous would persuade you to believe.

There have been a number of circumstances in which it is proven, for example, that the market overreacts to information, and therefore predictably reverses itself. It’s not clear, however, that one can make money from these phenomena, because the transaction costs of buying and selling the securities in question would likely more than wipe out any possible gain.

Seasonal regularities in the stock market have also been known for decades and confirmed by rigorous statistical analysis. These include a tendency for stocks to go up in January, and to go up on Fridays and down on Mondays. The psychology (or maybe rational economic decisions) underlying these effects can only be surmised. These are only tendencies, not predictable repeated patterns, and again, it’s very unlikely that you can make money by trading on these patterns.

Then, too, many quantitative analysts (those who use computerized methods that are statistically tested and driven by large quantities of data) incorporate some version of “price momentum,” that is to say, price trends, in their stock selection procedures. I can’t vouch for the predictive value of price momentum; I am saying that stock analysts who know how to perform statistical tests have evidently found that it’s good enough to use as one of many predictors.

Most significantly, there is some very interesting and continuing research into technical patterns over very short spans of time, like minutes or seconds. You may have heard the term “high-frequency trading,” which is what this is all about. Over such short intervals, real economic news that might affect the prospects for an investment is very, very sparse, so most of the influence on changes in price is probably the psychology of those who are trading and what they divine in the patterns of historical prices—but very, very short-term history. Professor Andrew Lo of MIT has for some years led a research program into technical analysis (and not just over short spans of time) and recently published the first in a trilogy of books on the subject.6

In short, there may be something to technical analysis, but either that something isn’t useful for making money, or if it is, you have to be able to trade at extremely low costs, and if you’re not buying and selling by the minute or second, you’re going to require something like an MIT graduate education in finance.

You’re not going to make money by visual inspection of price charts and divining the hidden messages in their patterns. And you shouldn’t believe for a moment anyone who says he can do this.


So we’ve selected investments. Now what?

Selection of an investment doesn’t imply what to do next. Obviously, you can choose to buy or to sell (or toshort, which is a form of selling). But you can also choose to do nothing. You might, for example, think that once you determine that an investment that you own is priced at more than its intrinsic value, you should sell it. This is not, however, what Warren Buffett necessarily does. But a proper consideration of Buffett’s investment methods would take us off on a tangent. Let it suffice to say that deciding whether and how much to buy, to sell, and to hold is a matter of portfolio construction, which we will consider in a later article.

Is security selection worthwhile?

The question may seem surprising, given how I have defined security selection. At some level, an investor must engage in security selection, even if this means only choosing asset classes; without security selection, there’s nothing to put into the portfolio.

But it is worth remembering that in selecting individual stocks or bonds, not everyone can be a winner. That is, not everyone can choose stocks that will produce better returns than the stock market as a whole, or bonds that will beat the bond market. Far from this: the chances that any single investment manager, identified at random, will beat the market are not favorable.

Consider stocks. The stock market’s returns as a whole are the average of the returns of all investors in the market, after taking into account the amounts of money they are investing. Half the dollars invested in the stock market will perform better, and half will perform worse. Speaking very roughly, to get better returns than the market, you or your investment advisor has to be in at least the top half during whatever measurement period you choose to analyze.7 And if you believe that there is at least some element of luck in investment results, then some of the top half of investment managers achieved their distinction through luck alone, rather than skill, and therefore cannot be relied upon to repeat their superior performance.

Don’t be fooled by the claim—which you will see asserted now and then—that “now” is a great time for picking stocks. There is never a time when most people who select stocks are better than average. Similarly, you may from time to time see a report showing that, in some year just past, a majority of mutual fund managers had better returns than the stock market. If that was so, then someone other than mutual fund managers—Hedge fund managers? Institutional money managers? People advised by their stockbrokers?—must, on average, have had worse results than the market. Or, maybe many small mutual funds sometimes beat a few very large mutual funds. (I’d buy the argument that some times are better than others for those who do have skill at selecting stocks to prove their abilities, but the claim is seldom qualified in that way.)

This argument is irrefutable. It also in no way depends on the notion of market “efficiency,” which we will consider in a later article. Basically, roughly half the people who select stocks are not good at it. And even if all of them improve their skills, still, roughly half of them will not be good at it, because “good at it” is relative.

“Apple is a great company and a great stock to own” is casual and sloppy fundamental analysis, and “Citibank stock have been beaten down so far that now it’s a good bet to go up” is casual and sloppy technical analysis. Anyone who picks stocks had better go a long way beyond this kind of thinking if he hopesconsistently to place in the top half over time. But many investors have a more modest goal than “beating the market”: They aim only to have a portfolio that serves their financial needs, and they (and their advisors) can choose investments wisely for portfolio construction without competing to be a winner in security selection.
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1 Sometimes “quantitative analysis” is used to refer to a third kind of tactic, but computer-implemented methods along this line are generally some sort of mechanical, numbers-driven fundamental analysis with an occasional admixture of technical analysis.


2 I’m ignoring issues of illiquidity, when the most recent known price may be an old one, and therefore not relevant to current circumstances.


3 www.mta.org.


4 There are, indeed, practitioners of stock selection through astrology, who can’t be classified as either fundamental analysts or technicians. Fortunately, they are very few. I used to keep on my office wall a copy of a horoscope cast by a Mr. Samuel Jeake (1652-1699) for the moment that he bought shares of the Bank of England, as representing a significant moment in the history of stock selection methods.


5 The reader who is familiar with the concept of discounting will realize that the only way that the first and second propositions can be simultaneously true is if the discount rate is continuously changing, which is crazy, regardless of whether the changes are predictable.


6 Andrew W. Lo and Jasmina Hasanhodzic, The Heretics of Finance: Conversations with Leading Practitioners of Technical Analysis (Bloomberg Press, 2009). This first book actually doesn’t demonstrate anything about technical analysis. It’s a series of interviews with prominent technicians, exploring how they got into the field and how they think about investments.


7 These statements are only very approximate. I will go into this subject in much more depth in later essays. On the one hand, the median, which divides in half the entire range of returns, is not the average; for the stock market over time, it is greater than the average, and the consequence is that more than 50% of historical stock market annual returns beat the average. Within any given period of time, the median stock return is also greater than the average stock return. Also, there are, presumably, many advisors managing small amounts of money invested in the stocks of smaller companies, and fewer advisors managing large amounts. But some of those small managers, such as individuals advised by their stockbrokers, may simply be carrying out the instructions of large investment companies, so the definition of who is a manager of large amounts and who is manager of small amounts can be disputed. On the other hand, very few managers just hold the same stocks indefinitely, so, over time, the opportunities for any one manager to have performance worse than the top half of all stocks increase in number the longer the period under consideration. And the costs of buying and selling eat into the investors’ returns. The median manager is going to have worse performance than the median stock over time.

One Pilgrim's Progress

Some readers wonder whether I overstate the importance of psychological issues in the quest for consistent portfolio success. ("Aren't trading strategies and skills more important?") Surely, without sound, reliable methodologies, an investor cannot hope to be profitable. And yet I believe that an investor's psyche to be more important than consummate skills to achieve consistent and enduring success. You can know all the patterns, have all the skills, and yet remain unable to pull the trigger.

There are key ways you can cultivate the proper mental edge.
• Remain calm and relaxed. You should manage risk on each investment. If you truly know that an investment, held currently at a loss, has relatively little impact on your account balance, you will be more easily able to remain calm.
• Attitude. Many investors are afraid to face the worst-case scenario, which is that they cannot invest profitably, or that they will ever achieve lasting success. Do not be afraid to face your limitations; instead, work around them. With realistic optimism, you can beat even the most seemingly insurmountable problem.
• Focus on the process, not the result. Many investors become bogged down because they focus on making big profits. You end up putting extra pressure on yourself to perform beyond your skill level, and when you do that, you usually choke under the pressure. It is better to focus on the process of investing. Focus on learning how to invest correctly and profitably rather than on the extrinsic, monetary rewards of investing.
• Focus on meeting your own internal standards. Better than to measure your portfolio performance against other investors for how well you should be doing. Everybody has his or her own unique learning curve. Some people pick up investing relatively quickly while others need to spend a great deal of time honing their skills. Do not make the mistake of thinking that just because you are not doing as well as other investors that you have less talent or are doing poorly. Your timeline is different.

Investing is difficult enough, but the multitude of methods can be downright stunning. Just look at your choices: stocks, futures, options, mutual funds. Then you have to determine an appropriate level of activity: day trading, swing trading, buy-and-hold. Even your strategies are numerous: scalping, spreads, system trading, directional. It is easy to be overwhelmed. One of the major pitfalls of active trading is trying to master all of these choices.

Smart investors give themselves an edge by doing one thing well. Plenty of traders have made fortunes just buying and selling one stock repeatedly. Others have mastered the art of options spreads, while some have even profited from the reversals that often occur after news events push a market to an extreme. But nobody has ever made a consistent profit by trading all investment options.

Many examples abound why it is better to focus on one theme, but consider the advantages of mastering one single stock. The popularity of computerized systems trading is growing, but these 'systems' can be somewhat misleading to a naïve investor. The criteria set that works great for one equity could be disastrous when applied to another. The idea here is universal; if you want to be a successful investor, you must give yourself an edge. You can do that via mastering one stock, one trade, or one signal, and then execute it perfectly. Remember, investing accurately is more important than investing frequently. Thus, it is more crucial to invest with confidence rather than skill. You must take action when the moment is ripe, not rotten. And only you (your mind, your outlook, your psychology) holds yourself back from consistent success.

We all, as humans, are risk averse. We have a strong need to seek out pleasure and avoid pain, which means in this context that we do not like to incur losses from our investment efforts, and we'll do almost anything to avoid taking them. Losses are painful; investors tend to come up with many ways of denying a loss -- such as holding on to a losing investment and hope it turns around. In the end, though, you will invest more efficiently and profitably if you can take losses as quickly as possible, and then make a new investment. The best way to do this is to have a clearly defined investing plan in which you pre-define the reasons you will enter and exit an investment. Once you have such a plan, you then can execute the investment without hesitation: Nothing to consider, weigh, or judge and consequently nothing to tempt you to hesitate and be consumed with self-doubt. The best way to take a loss is to anticipate it. Do not be caught off guard. If you invest with the expectation  an investment opportunity could lose, you won't be as bothered should the investment go against your hopes; if you avoid considering the possibility, you'll become extremely frustrated when you are in the midst of a losing investment. Accept that losses are the norm rather than the exception, especially the briefer your time frame to fruition.

The problem becomes that we each want to own the big movers, the stocks that grab the headlines; unfortunately, this attempt often gets in the way of our making money. This is a fantasia that continues to plague me, despite my decades-long attempt to corral it. I scan the markets to determine what moves now, and moan that I am not aboard. If I, or you, were to suddenly jump aboard this or that runaway train, then what knowledge do we have regarding the company? When things go wrong (usually expressed as the stock declining suddenly and ferociously) we are left with only the questions we should have asked before buying into the position. Oh, and the loss.

So I develop a list of companies I want to own, and from that list I await my moments of opportunity to purchase. While I wait, I study the company and watch how its shares trade: each stock has its own peccadilloes that betray something, no matter how inconsequential for a specific time frame. And while I am busy doing all that, other stocks on my buy list are moving. In fact, stocks are moving all the time — I merely await the pattern or setup with which I am familiar or comfortable. When that occurs, I act.

I am wrong so often, it hurts. Trading, speculation, investing (recall I denote the critical difference as one of time) are, in themselves, each sufficiently difficult not to complicate the matter by conflating your emotional vacillations with the market's oscillations. If something goes wrong, sell and move on; if something goes right, then sell and move on. But this is difficult, isn’t it? Who wants to admit to being wrong by stopping out for a small loss when, if we grant enough time, it will go up… Right? And who wants to take a profit, large or small, when, if granted enough time, the stock will go higher, much higher. ("I had it when.")

Give it up. The effort is not to buy the low tick or sell the high tick, or even having owned it whenever, but for your portfolio to amass an increasing value. Does it matter how it got there? It is for this core reason that I fixate on investor's psychology: 99% of success in this venture is based upon your decisions, not the market’s oscillations.

Knowing everything about a company merely serves to whet our appetite, but little about its shares; whether now is a good time to buy, a recognition of your time frame and tolerance for risk. No one other than you can answer those questions; the answers are internal not external. After analyzing the company and considering it a fit for your portfolio, you still must determine how many shares, when to buy (and sell), and when do you recognize the error of judgment based on either (or both) the stock and the company. LaPlace said, "The most important questions of life are, for the most part, really only problems of probability." In the face of this uncertainty lies your prowess to make decisions now.

Stocks oscillate. But if you buy stocks that trend upwards, then weakness in the general market should result merely in short term weakness in your up trending stock; i.e., a buying opportunity. The trick is to recognize when a trend is about to reverse from up to down (or down to up). Because the effort to buy during a decline is difficult, you might find buying higher easier to accomplish. Of course, this also potentially means that the moment you finally feel comfortable buying is the same moment you should sell.

The problem is the amount of volatility within the existing up trend. Any investment is a difficult hold for the emotional investor. If the potential opportunity for an investment excites you, what do you do about it? Do you buy, and grimace through the gut-wrenching volatility? Despite your recognition of the company’s opportunity, and its proven success in the market already (evinced by a rising share price), who wants to buy in advance of a sudden sharp decline in price? And before the trend resumes?

At some price or level, the shares represent value to you, irrespective of any additional downside volatility subsequent to your purchase. So you buy then because the investment is appropriate for your portfolio, and further price weakness is inconsequential to the opportunity you foresee.
-- David M Gordon / The Deipnosophist

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

The Complete Guide to Investing in Index Funds - A review

The Complete Guide to Investing in Index Funds
Craig W Baird

Craig Baird begins his book, THE COMPLETE GUIDE TO INVESTING IN INDEX FUNDS by offering definitions: definitions of Wall Street jargon, definitions of acronyms, definitions of concepts. And a lot of history of financial products. If Baird offered only the definitions and history, the book would qualify as a good volume for tyro investors.

With investing in index funds as his primary thesis, Baird should devote most of the book to definitions (check), history (check), how to invest in index funds (check), why to invest in index funds (um, no check). Baird sprinkles his book with many value judgments that are open to vociferous argument; his worst precept, though, is his contrast between "active" and index investors. Consider the three snippets below that illustrate this problem:
• "An effective way to understand active investors is to compare them to gamblers. Their style of investing often goes on a gut feeling. Most active investors believe they have a special understanding of the market that others lack, which gives them an edge over everyone else. No different than gambling, active investing can be a hectic ride for investors that [sic -- dmg] enjoy the feeling of excitement through risking it all on the chance of the stock market." (p 57)

And

• "Active investors can be considered gamblers in disguise. Investing can turn into an addiction that can cost them everything, much like playing roulette can." (p 100)

Finally

• "Index fund investors can enjoy a relaxed state of mind because they are not pressured into beating anything, and they can approach the market by buying and holding globally diversified portfolios of index funds. This method of investing is supported by University of Chicago Nobel Prize winners." (p 60)

Baird's distinction is a cheap trick of argumentative logic; gosh, don't you want to align your portfolio efforts alongside a bunch of Nobel prize winners? Surely a group of smart guys, in any field (of course, Baird does not mention the discipline this group of people won their Nobel prizes, although he implies it), achieve fantastic rates of return on their investment portfolios. Right...? And any investor who invests with a plan and methodology can "enjoy a relaxed state of mind"... Right? I know many active investors whose methodology does not rely on gut feeling, but reasoned analysis. And disciplined investors invest dispassionately, never emotionally. Yes, amateur investors rule the roost, but that merely helps create the pricing inefficiencies Baird ignores, and that endure longer than a nano-second. Whoever Baird interviewed before writing this book, he missed the narrow field of professional investors, who know the what, where, when, why, and how of their profession.

One insight you will not find in his book: indexing has grown to become the tail that wags the dog, precisely because index investing has grown like a weed the past ~38 years, and especially the past 15 years. To his credit, Baird notes this phenomenon; unfortunately, he misses its effect. Index funds now are more the market than the market itself. Also is the phenomenon of a stock spiking on the rumor (or news) of its inclusion to an index. The active investors Baird disparages profit from the ephemeral pricing disparity that results, while index investors pay the higher price.

Which obliquely points out the true disparity between types of investor, time. The more time an investor grants while he or she awaits fruition of the investment, the less stress results from short term oscillations of price. (Price smoothing of risk via elapsed time.) But that effect is the same for all investors. Know your true investing objective helps you to invest successfully, and not gamble.

Fact is, any form of investing can resemble gambling, index investing included. We investors complicate the process to such a degree that we only confound and confuse ourselves. Investing, otherwise a simple process, thus becomes akin to gambling:
• We lack understanding, which results in
• No control of the process, which results in
• Losses.

This is where Baird's The Complete Guide to Investing in Index Funds really shines, as introductory text for investors who lack the rudiments of successful investing. What Baird offers his readers, he does well; with the book's many definitions, explanations, history, and brief biographies, this book makes for an excellent holiday gift for beginning investors.
-- David M Gordon / The Deipnosophist

Always expect the unexpected

Non-recognition → Recognition → 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.