One of the keys to being successful in the stock market over the long-run (we’re talking decades, not years, months, or weeks) is to be have a discipline that you can depend on. Make no mistake about it; there are lots and lots of ways to make money in the market. But, there are two vital things to understand. First, not all methods will fit your personality. And second, nothing – absolutely nothing – works all the time. (Hence the need to have a disciplined strategy that you understand and can stick to when the going gets tough.)
One of the biggest mistakes individual investors make is to constantly change their strategy. It seems that for many investors, once a system or trading strategy produces a couple of losses, they tend to toss it aside and continue on in their search for the Holy Grail.
But here’s a tip. While there is an indicator named the Holy Grail (which, by the way is FAR from perfect), there is nothing in this game that works in every market environment. Trend following has its flaws. Day-trading causes you to miss big opening moves. Mean reversion works well in some environments and not at all in others. Discretionary trading is wonderful when you are on a roll, but…
In my humble opinion, one of the keys to the game is to be able to first identify the type of environment that you are dealing with (uptrend, downtrend, consolidation, bad-news panic, news-driven environment etc.) and then know what tools are appropriate for use in that environment. Or you can build a market model to do all of that for you.
From where I sit, the single most important piece of advice I can offer the individual investor is this: Trader know thyself. In short, you need to understand what you can and can’t do from an emotional standpoint.
Some people can easily bomb into a position with 100% of their portfolio using leveraged positions and maybe even some margin. Then there are others that can’t handle even a 5% drawdown on a trade. Thus, before you decide what is the best way to invest, you’d best understand what type of investor you are.
The other big issue that trips up the individual investor is that markets change. There have been many market indicators and rule-based strategies that have worked well for many years only to suddenly stop working due to a change in the market environment.
For example, during the 1980’s a successful market timing firm I worked with employed a fairly simple breadth model to determine their buy and sell signals. When the total number of advancing issues on the NYSE exceeded declining issues by more than 500, the model produced a buy signal. And when there were net 500 declining issues, a sell signal was given. For many years, this worked well and the firm prospered.
However, the character of the NYSE advance/decline line slowly changed over time as the exchange listed more and more closed-end mutual funds, REIT’s and other bond-like vehicles. In short, the change in character of the advance/decline data dealt a severe blow to this breadth-based model and eventually the firm disbanded due to an extended period of bad performance and the inability to both identify and adapt to the changed environment.
A similar situation occurred when stocks went from being traded in eighths and sixteenths, to decimals. Suddenly, all of the breadth statistics were very different. The bottom line to this change is it took much less price movement in order to create an advancing or declining issue on any given day.
Another example would be the relatively well-known “10-to-1 up day” buy signals and “9-to-1 down day” sell signals. For many years, buying when up volume exceeded down volume by a measure of 10-to-1 was a good indication that stocks were likely heading higher over the next 1, 3, and 6 months. According to Ned Davis Research, the S&P 500’s mean gain after up volume exceeded down volume by a measure of at least 10-to-1 over the following three months has been +4.1% since 1950. This compares quite favorably to the average return of +2.0% for all three month periods.
And when a second 10-to-1 signal has been given without an intervening sell signal, the returns are even better. Over the next three months, the S&P averaged gains of +4.5% vs. +2.0% for all three month periods. And over the next six months, the S&P showed cumulative returns of +11.4%, which is more than double the average of +4.1% for all six-month periods.
However, a change in the market’s environment has hurt this reliable indicator. In short, the recent advent of high frequency trading has caused this indicator to lose its value. The problem is the frequency of the signals has increased dramatically over the past few years. From 10/1/80 through 12/31/07 – a period of 28 years – there were a total of 40 buy signals given by this indicator (an average of 1.4 buy signals per year). But from the end of 2007 through 10/28/2010 (a period of less than three years), there were approximately 42 signals – or an average of nearly 15 per year!
Yet another example of an indicator losing its effectiveness due to changes in the market would be the put-call ratio, which was invented by Martin Zweig in the early 1980’s. Once a key indicator of speculative activity, the advent of sophisticated program trading, hedging, and asset allocation systems have rendered the indicator (in its original form) all but useless as a buy and sell indicator in today’s environment.
Speaking of Mr. Zweig (who was one of my “heroes” when I first started in the business in the early 1980’s), if you haven’t read the book “Winning on Wall Street,” I’d strongly recommend it. While the models he highlights in the book need updating, his approach to model building is something every investor should be exposed to.
In the book, Zweig introduces something called the “4% Momentum Model.” The concept was simple enough; when the Value Line Composite rose by 4% a buy signal was triggered and when the index fell by 4% a sell signal was flashed. While the overall batting average of trades isn’t so hot (just 48% of the trades have been profitable since 1964), the system produced an average annual compound rate of return of 15.4%, which is more the double the buy-and-hold average of 7.3%.
However, as you might suspect, the increase in volatility and the use of high-frequency trading has caused the number of signals from this indicator to explode over the last four years. Thus, if one were following this system exclusively, they might be ready to pull their hair out by now.
The key lesson to learn here is that the characteristics of the market
