Market Trading Tactics - Part 2

This is a continuation of the previous post.

In the last post, we discussed how lessons learnt from traders apply to investors. As market participants, we really have very little control over our destinies unlike most other activities. A tennis player can always decide whether to be aggressive or defensive, to target opponents’ weak backhand or serve to kill. A businessman, likewise, can also do a lot, such as using discount pricing or scale to squash opponents or headhunt the best talent in the market to run his business. But for investors and traders alike, we are in a game where we control only one lever. We pull it to buy, release to sell, and the length of our pull determines our bet size.

Maria, still the most beautiful tennis player.

In other words, as market participants, we can only determine our entry price, our exit price and the size of our trade. This game is really quite restrictive. Hence the lessons from the last post would hopefully serve to remind everyone that in this game, we are our own worst enemies. The crux of success boils down to superior analysis and managing our psychology. I would think that psychology is more important than superior analysis.

Previously, we discussed the first two points about control and style. Today’s final point is about our own emotions. Particularly how our emotions would create what Daryl Guppy (the author of the book Market Trading Tactics) called an emotional stop loss.

In my years of investing, I have not really thought too much about this. Luckily or unluckily, I believe I never hit this stop loss. An emotional stop loss is the amount of money that we cannot afford to lose emotionally. It could be $10,000 or it could be 10% of the portfolio. If we were hit by this magnitude of loss, we feel really bad emotionally and we start to break down. We cannot think rationally and make stupid decisions. We are very likely to just sell out everything, hence cutting loss at the worst time possible, only to see that things recover after that. Obviously, this is different for everyone but we must recognised it’s there.

To make things more vivid, let’s put in some no.s. Imagine that we have a $100k portfolio and our emotional stop loss is $20k. But we did not know this. We put $25k into a pharmaceutical stock hoping to make 20% since our analysis showed everything was great and a new drug would be launch soon. Lo and behold, the company announced the new drug failed and it goes down by 80% in a week. So we lost $20k in a week. This is 20% of the portfolio. We just lost a couple of years of overseas trips at a click of the mouse button and we needed that for the downpayment of a new car. We panicked and sell out, shared the bad news with our spouse and faced the music, only to see the stock recover in the months after.

This is the emotional stop loss.

It is very much similar to a nervous breakdown or a snap. Our psychology makeup somehow works like a rubber band, if we are over-stressed, or over-stretched, we will snap and when that happens, it's very hard to recover. We sometimes see this even in friendships. People who are good friends for years but time after time tension built up and one incident (like a friend refusing to just put a Facebook Like when requested perhaps) can ultimately bring about some kind of a crunch that could simply bring the other to conclude, the friendship bond is broken. It could be repaired but it will not be the same.

Can we accept these friends?

So to make sure this never happens, we need to size really well. We need to think in terms of both absolute dollars as well as percentage of the whole portfolio. We would also need contingencies. For me, the rule of thumb would be never putting more than 10% of the portfolio in any single name. In fact, I would try not to get close to 10%. If the stock rises that much, then it’s best to sell out a portion of it. Of course, starting a position small definitely helps. Starting a new position at 1% and then look to build up as we learn more seems like a good strategy.

Our relationship with money is unique and the way we handle it is also unique in the history of mankind. From the caveman era till modern society, humans always dealt with physical possessions and very seldom the concept of virtual wealth as we do today when trading with screens and computers. Human activities in the stock market only started recently and hence its impact is not well understood. It is famous or perhaps infamous that Sir Isaac Newton lost a fortune in the early British stock market. For a genius like him to lose a fortune, what are our chances if we don't try hard to understand what we are up against?

"I can calculate the motion of heavenly bodies, but not the madness of people." - Sir Isaac Newton

It is said that every trade should be more akin to the decision process we make when we buy houses or for some entrepreneurs, buying and selling businesses. When we are looking to buy our matrimony homes, or a future nest, we really do serious stuff. We go for multiple viewings, we study maps, understand localities, we interview neighbours, we research markets. Well, at least I believe most of us do some of these when deciding to put hundreds of thousands. Yes, while each stock position will be just a fraction of homes or businesses, the due diligence should not be proportionately less. Even for trading, we need to do a lot more work than we think for each trade. I would say that the checklist should be at least 7-8 steps as I have depicted previously. But it's not easy. It takes effort. This is why so few ever succeeded in making huge sums from the markets.

This two part series on Market Trading Tactics hopefully gives us another tool to get there. To summarize:

1. In investing, we control only three variables: the entry price, the exit price and the size. Of these sizing is the most important, followed by the entry price. We get these rights by doing deep-dive analyses, understanding the intrinsic values well and buying way below them. It also means patience. Sizing comes with experience and it's important not to size it too small that it doesn't move the needle. Or size it too big such that it hits our emotional stop loss.

2. We have to know our styles. Some of us are bulls and other bears. Bulls tend to get in too early and bears too late. We have to adjust how we then enter markets. Bulls should enter small and build up. Bears have to enter big and/or try to be a bit earlier but with a smaller stake.

3. We must never hit our emotional stop loss because we cease to function at the high mental capacity to invest or trade. We need to do better analyses and know our own psychological makeups better in order to beat the market!

Hope this helps! Huat Ah!

Happy Deepavali to all!

Market Trading Tactics - Part 1

I bought this book titled Market Trading Tactics for ten years ago and left it on the shelf. It stood there ever since, collecting dust. At the back of my mind, I didn’t want to read it. I couldn’t figure out why I bought it in the first place. I am an investor and as an investor, there was no need for trading tactics. In my mind, traders and investors were enemies. We were the Allied Powers and them, the Axis Powers. The markets were our fighting ground. So how can I read a strategy book devised by the enemies?

I was so wrong!

Recently, in order to fulfil my mission to shift all my reading onto Amazon’s Kindle, I decided I have to quickly finish the last of the few hard copy books left on my bookshelf. Market Trading Tactics begged to be unwrapped. Yes, it was still wrapped in plastic which had turned yellow. So I did unwrap it and read it at full speed. I was done in two weeks.

Market Trading Tactics by Daryl Guppy (2000)

To be honest, the bulk of it was not what I was looking for. These were about moving averages, trading indicators, chart reading etc. I maintain my view that if past prices could predict future prices, then the infamous stats would be reversed: 90% of all market participants would make money by trading stocks and a lot of professional traders would be billionaires. Billionaires not just millionaires. Past prices and trading volumes do provide some information useful to long term investors and traders alike but not to the extent that it can help anyone beat the market consistently. I still believe it is much harder to generate long term 8-10% annual return by trading.

The anecdotal evidence was provided by the author Daryl Guppy who wrote about his own trading career including how much he could make by trading. These were really interesting stats. He shared that in one year, he made $60k profits on a base of $100k, making trades every two weeks (i.e. about 30 trades for the year), while adhering to the various rules that he set for himself, including stop losses, limits on capital risked per trade etc. He also shared that his average trade size was about $30k and his win rate was 70%. Of course, if he could replicate this for 30 years, then he would have beaten Warren Buffett. Since his net worth is still much less than that of the Oracle of Omaha or for that matter, many less famous value investors (yes, I am passing judgement here :), we have to assume that this should be one of his best years.

Having said that, I did learn a lot as an investor and some of this knowledge could actually be applied well to what we do. Here’s three nuggets that I found pretty useful:

1. As a market participant, we could only control three variables, out of many, many variables that goes into generating returns.

2. We need to know our styles, are we inherently bullish or bearish and how we should correct for our biases.

3. What is our absolute emotional stop loss?

You have to cut loss! You have to!

Ok, that's Korean drama style, we are not there yet. Let's tackle them one by one.

The first one should have come as common sense but I never really gave too much thought about it until I read the book. The author described it really well. So he said that in most activities that we engage in, we usually have a lot of control. Be it playing tennis, running a business, cooking etc. In running a business, we decide how to launch products, where to launch, at what price, who to hire, where to do promotions, what to do with e-commerce etc. Successful businessmen made lots of good decisions that propelled their businesses forward and beat competition. But as an investor or trader, we can only control three things. Yes, three. Our entry price, exit price and size of the trade (relative to our portfolio). That’s it.

Yes, there are activist investors that nowadays try to influence businesses, getting great outcomes, but for most of us, that’s pretty much the only things we can control. So, how do we win given what we can do is so limited? Hence what really matters is really psychology which impacts how we control the three variables. We should never be taken for a ride by the markets, buying into euphoria and selling in panic. I would say that for long term investors, the priority of importance is probably the sizing, followed by entry price and then exit price.

Sizing is also related to the last point so let’s keep things simple for now. Every position should be big enough to matter but not too big as to jeopardise the whole portfolio. In my experience, it would usually be 2-5% of a portfolio. For really high conviction bets, it could go up to 10% but that’s really risky. If we are wrong then wipe out a lot of our net worth. Next, entry price. There is really nothing much to add. For value investors, this determines almost everything. We buy way below intrinsic value and earn the difference between price and value. If we are right, there isn’t really an exit per se, bcos the value compounds and over time, we see these become 5 or 10 baggers.

On this note, we move on to the second point which is about styles.

Most of us are predisposed to have some sort of biases. We are inherently optimistic or pessimistic, we have formed our world views earlier in life and we act according to these views. For me, I am inherently optimistic and this comes up in my investing style. I tend to bullish and hence tend to buy easily, usually catching the falling knife too early and the stock continues to fall after my purchase. But thankfully, most stocks recover afterwards as I got the long term story right. I also tend to overstay, even in stocks that I believe I should be exiting. The converse is true for bearish people.

In order to correct this, now I know I should always enter a position small. For instance if this stock should ultimately be a 5% position. I would start with 1-1.5%. Then I have 2-3 bullets to add to 4-5% over time. Usually the stock goes down after the first buy, and the second and third buys allow me to catch the bottom. As for selling, I would need to develop better selling techniques, by setting rules such as never have any positions bigger than 8% of the portfolio. Sell a third or half the position after the stock has gone up 100% etc. However, these tips are also very personal i.e. it differs from person to person. So you have to know your own style and develop techniques to better manage and control the three variables well.

In the next post, we talk about the emotional stop loss!

A Two Iteration Monte Carlo Simulation on Trading

This is something that I have posted in a comment some time back. I thought I would just expand it for discussion and see if it makes sense.

First let’s work through some assumptions and no.s and see what’s the expected return for trading.

1. The capital base is $100,000
2. $10,000 is utilized per trade
3. 10 trades is done in 1 year
4. Take profit at 20%
5. Cut loss at -10%
6. Winning rate 60%
7. Transaction cost $20

Based on these:

a. The 6 winning trades will bring in $12,000.
b. The 4 losing trades take away $4,000.
c. Transaction cost is $400.
d. Total winnings: $3800
e. Return 3.8% - Yeah that's life for a trader, my darling. Why don't you put the money in CPF and earn the same return?

Ok, there are a lot of assumptions, some might be skewed to put traders down. After all, this is a value investing blog. :) What if we tweak them around? Say the capital base is just $20,000 – then the return becomes 20%! However the rationale would then be it won’t be possible to realize 10 trades in 1 yrs with just $20,000.

Anyways let’s do a more aggressive one

1. The capital base is $50,000
2. $10,000 is utilized per trade
3. 10 trades is done in 1 year
4. Take profit at 15% (rationale being that the time horizon is now shortened)
5. Cut loss at -10%
6. Winning rate 60%
7. Transaction cost $20

Based on these

a. 6 winning trades will bring in $9,000
b. 4 losing trades take away $4,000
c. Transaction cost $400
d. Total winnings: $4,600
e. Return 9.2%

Ok that’s better than market return, but that’s probably also a high hurdle. To do 10 trades with $50k in 1 yr, reach trade can only go for 6 mths.

I think the appropriate scientific experiment we should do is a Monte Carlo simulation of 1,000 iterations to see what’s the true expected return. But my guess is it’s actually going to be less than market return (of 8% or so). Yes, actually if you do it correctly, a trader should earn positive return, not negative ones. And in all those books, it always says academic studies show that trading cannot beat market return after factoring in transaction costs.

Well this also implicitly means, if you get your transaction costs low enough, you might beat market return and becoming a Big Swinging Dick.

Ok, daydreaming over. Trading is hard. My sense is, it is actually much harder than value investing. If you do it right, you might just make average return. Most people don't do it right in the first few years. Think about the time and effort that is needed to execute these trades during the year. Basically it’s a full time job in itself. Not forgetting that it's gonna be one helluva emotional rollercoaster ride every day!

Well, that’s why I stick with value investing.

The ultimate bet

This post is related to the last one regarding probabilities and payoff and how we should bet.

We often hear about people betting their life savings of $100k on the next property of say $500k, hoping for that 20% rise before TOP and make $100k return (with a capital base of $100k). Lets see how this works in that matrix thingy we used in the previous post:

Let's give the benefit of doubt and say this guy has 70% chance of making $100k, he has read the property market well, the cycle is turning, the stars are aligned. However, again in life, since nothing is 100% one, we have to think that he also has a 30% downside whereby he will lose $250k (ppty of $500k goes down by $100k, mortgage $130k, legal fees $20k all add up to $250k)

Probability payoff
0.3 -250k -75k
0.7 100k 70k
Expected return -5k

Now we see that the expected return is negative. Even if we tweak the no.s here and there, which I did, the expected return is not high. You can probably get to expected return of $80k - which is good if you use $100k as the base. But in reality the base is $500k, bcos the guy borrowed $400k from the bank. So you risked a life of perpetual debt for $80k, is it worth it?

In real life, and not just paper math, if the 30% probability becomes reality, this guy is stuck with a $500k 30-yr mortgage on a house worth significantly lesser, he may have cashflow problem and need to sell out some time in the next 30 yrs, or declare bankruptcy. As we know it, his life is over. Well at least financially that is. He will never achieved the much coveted financial freedom, a nice cosy retirement nest egg and the kind of crap Robert Kiyosaki likes to preach.

Anothe way to look at it, we can think of such bets as extreme as this Russian Roulette game:

1 shot of out six has a real bullet.

If you win, you get paid $5mn, enough for a lifetime. (Well at least for me, I dunno about you though)

If you lose you die.

Odds are in your favour: ok let's make it even better, we have a revolver that can house 20 shots.
So only 1 in 20 chance you will die.

19 in 20 chance you never have to worry about money in life.

Will you play?

Betting when the downside is something we cannot afford to happen is not a good way to bet. Think about this when you are faced with such choices.

Probability and Payout

This is something that relates to the Kelly Formula but at a much more simplistic level.

Basically, it all started when some friend of mine had the idea that if we are 80% sure of a 10% upside, we should be punting big on this event?

Eg. we heard a rumour that the CEO of TSMC saying he wants to buy Chartered for $2.20 (Today closing price $2.00) from the secretary of the CEO of TSMC and he will announce it tomorrow. How should you bet?

Mathmatically, this event can be illustrated with the matrix below.

Probability Payout
0.8 10 8%
0.2 -20 -4%
Expected return 4%

In the first scenario, there is a 80% chance you earn 10% and in the 2nd one 20% chance you lose 20% bcos say for some reason, he did not announce it the day after, or something unexpected happens. In life, nothing is 100%, even if you are the TSMC CEO yourself, you cannot say for sure if you can make the announcement as planned. You might get murdered, or something else etc, Anyways, as such is the case, the expected return is actually about 4%, which is, well, lower than market return of about 5-8%pa.

My initial thought is that we cannot punt this kind of event to help us make big bucks. Given the inherent unreliability of a rumour, the low expected return, it is not exactly a good way to maximize wealth. Of course we can always tweak those probability and payoff to get a good expected return, but using logic and rationality, it is difficult to get a good expected return of more than 15%.

In value investing, I think the matrix looks like this:

Probability Payout
0.4 -30 -12%
0.6 50 30%
Expected return 18%

There is a 40% chance you will lose 30% of your money, but a 60% you make 50% (remember margin of safety and other safeguard put in place?) Your expected return is 18%. If you make enough of these during a lifetime - you are a clear winner.

The caveats here are:

1) your analysis must be quite accurate, ie the intrinsic value is really 50% higher than current price

2) the timeline here is long, it may take 3 years to realized this 18%, which means 6%pa

You might think this is just bcos I am promoting value investing. But if you play around with the probability and payoff you can still get 10+% payout on average, which would translate to only 2-3%pa but still it's positive number.

Back to the TSMC case, you can argue that the 4% when translate to annual return becomes 1200%pa. Spectacular! However the logic would be that you won't get to hear a rumour about a takeover 300 days a year... So looking at the absolute expected return no. regardless of the timeline becomes important. And if you play around with the probability and payoff for this, you do get negative numbers.

So with this in mind, hopefully you can do this simple exercise with your next stock buying and practise more value investing rather than punting!

Traders and Investors

Just like to share my own definition of traders and investors that I thought about recently...

First let's start with Ben Graham's definition of investors and speculators.

Graham first stated that an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return and operations not meeting these requirements are speculative.

So an investor focuses on analysis to look for capital safety and adequate return. This is usually interpreted as fundamental analysis of the company, its business model, its competitive advantage, margins, sales growth and of course, the financials: cash on hand, debt, bankruptcy risk, capex needs etc.

Anything less of such analysis means speculation. A speculator is simply one that doesn't do that kind of rigorous analysis.

Simple right?

For me I think it's about different focuses.

An investor focuses on value.
A trader focuses on price.

An investor is interested in the value of a stock (or any other thing he wants to buy), and he spends an awful lot of time and effort to figure out this value (or intrinsic value). This is analogous to Graham's analysis. Or more accurately rigorous fundamental analysis of business operations and financials. Price serves only to tell him how much he actually has to pay if he were to buy the stock. Needless to say, the lesser the better. Graham and most value investors advocate buying 30-40% (margin of safety) below the stock's intrinsic value.

To an investor, profit is made when the stock price subsequently rises to its value which usually take years.

A trader is interested in the price of a stock and he spends an awful lot of time and effort following how the price has moved. Actual value of a stock basically serves no purpose for the trader.

To a trader, profit is made when the stock rises above his buying price and he sells it to another person willing to buy at a higher price. Usually also known as the Greater Fool.

So, that's that! Just two different philosophies here to make money.

Getting Whipsawed!

Whipsaw is a wonderful description of a trade. Specifically you buy some stock, it goes down 20% and you sold out, intending to preserve whatever capital you have left. And the next thing you know, the stock goes up 100%! Shiok right!

Actually the fear of getting whipsawed is so great that it causes a lot of investors to make silly mistakes. But if you think about it, even if you really get whipsawed, it's not a big deal except for the psychological factor. Say you cut loss at 10% and the stock subsequently rallied, so you would have lost just 10%. But if you did not cut loss and stock continues to decline, you will eventually lose maybe 50-60%.

Let's for argument sake, make the example a bit more mathematical. Say you bought a stock at $10 and it plunges to $8. There is a 50% chance that it may rebound 50% to $12 and 50% chance that it plunges another 50% to $4.

So you have two choices now:

Choice 1: If you cut loss, you lose $2

Choice 2: You wait out the storm,
If you get lucky, you make $2, as the stock rise back to $12
If you are damn suay and the stock continue to plunge to $4, you lose $6

Let's assume it's 50:50 between the $2 and -$6, your expected return of not cutting loss is $-2 (0.5*2+0.5*-6), which doesn't make you better off than if you had cut loss. Actually it's probably 70-80% chance that it will go down. Logically thinking stock at $10 which had gone down to $8 should continue to decline bcos something had gone wrong in the first place. So unless a new positive catalyst appears, the stock will not rally.

However the fear of getting whipsawed is so great that it blurs the rational mind. If the stock did rebound and go back to $12, most pple would rather kill themselves than to admit that they only lost $2. This fear of getting whipsawed makes us hold on to our losses longer than we should.

Gambler's Ruin Takeaways

Well actually, Gambler's Ruin has more to do with speculating than investing. Nevertheless I think we can learn a few things from Gambler's Ruin.

Btw Kelly's Formula is

% of money = odds of winning - (odds of losing / payout)

Eg. You think Stock A that have a 60% chance of going up 80%
Then % of money = 0.6 - (0.4 / 0.8) = 0.1

ie you should be putting at most 10% of your money in this stock
But take note that ALL the inputs are arbitrary, the odds, the payout.
The formula output is only as good as the inputs.

Ok here are the takeaways:

1. If you simply buy a fixed dollar amt, like $1,000 for every stock you will go broke as time passes, even if the odds are fair. And you will go broke even faster, esp if the odds are against you. (As far as investing is concerned, in most cases, the odds ARE against you).

2. Even if the odds are in your favour, betting the same absolute amt doesn't make sense, you need to apply Kelly's Formula or its variations to optimize returns. This means that you should always decide how much money to invest based on a % of your total amt of money and not an absolute amt. And this % should be decided by the Kelly's Formula or some modifications (half Kelly etc) of it.

3. Building on the previous point, one of the most popular implementation is actually the much talked about rebalancing method used by institutions and shrewd indvidual investors. Say you have 60% in stocks, 30% bonds and 10% cash. You should rebalance your portfolio whenever the ratios are out of whack. Like maybe stocks go up to 70% during boom time, so bring it down back to 60%. This makes sure you buy low and sell high and at the same time mitigate Gambler's Ruin.

Ben Graham, father of value investing, advocates always maintaining a ratio of 50:50 in stocks and bonds (with possible digression to 25:75 or 75:25). In the same line of thought, when the ratios are out, say stocks go from 50% to 80%, then you should bring it back down by selling. This ensures that you buy when it is low and sell when it is high.

Gambler's Ruin

Here is a tip for this Chinese New Year gambling.

The concept of Gambler's Ruin was mentioned in a very insightful book called Fortune's Formula which I thought deserve more scruntiny, both from gambling and investing point of view.

The story goes as follows. Imagine you have some money and you decide to bet a fixed amount in a game where your probability of winning is 50%. Say you have $100, you want to bet $1 on "Big" and "Small" (and in this case, there is no "House Win" like double sixes. Bcos if there is "House Win", your winning probability would be less than 50% which we do not want in this story yet).

So what is the probability that you will lose all your money after some time?

Well it's 100%!

This is intuitively illogical bcos the odds are 50% right? Why should one lose everything? Well the caveat here is "after some time" which is as good as saying "playing forever". If you play forever, you are bound to lose everything, which can be shown mathematically and that's what we are gonna do in this post. If you decide to stop after winning a certain amt of money, then good for you, it's possible that you achieve your goal and leave the casino with some money.

The mathematical proof of why you can expect to lose everything if you play for a long time (or rather forever) goes as follows:

The probability of either losing your money or doubling your money is 0.5. Consider these mutually exclusive cases:

Case 1: Probability of losing all your money after X1 no. of bets = 0.5
Case 2: After X1 no. of bets, you have doubled your money (0.5), but you continue to play for another X2 bets, so probability of later losing everything again = 0.5*0.5 = 0.25
Case 3: After X1 + X2 no. of bets, you double your money yet again, lucky you! (0.5*0.5), but you continue to play another X3 bets, and the probability of later losing everything = 0.5*0.5*0.5 = 0.125

The no. of cases go on and you add up all the probability that you will go broke = 0.5+0.25+0.125+... = 1

So, as long as you bet the same absolute amt, even in an even odds game, you WILL lose everything in the end.

This link allows you to simulate exactly what will happen and I tried it and recorded down that it takes about 20,000 games to go broke if you have $100 and the odds are 50% (which is quite a lot, but still the math is against you). If the house odds just goes up by 5% (ie your probability of winning is 45%), you lose everything in less than 1,000 games.

So what to do? Well the book says that you should follow this formula called Kelly's Formula to decide how much to bet (which is a % of your money rather than a fixed absolute amount). In this case, the formula actually says don't bet though...

So don't keep betting $1 during the usual CNY Big/Small game. Vary your bet size according to Kelly's Formula!

DCA: When the market down, BUY MORE!

Value investors rejoice when the markets go into correction mode. Bcos that means they can pick up good businesses at bargain prices. Logically and intuitively, this makes perfect sense, but somehow our ape-evolved brains are not wired to think that way.

When the markets have rallied for some time and it goes down, we panic. When they subsequently rebound, we curse and swear that why didn't we buy more during the correction. And when the markets go into correction mode for 3 years, we get totally not interested in the markets. Many don't ever return to invest, even though it's the best chance they got against inflation.

So some have come up with a method to counter this flaw and help us invest wiser. It's called Dollar Cost Averaging or DCA for short. It simply means that you put the same amt of money to buy stocks/UT/index funds etc at fixed time periods.

The logic is that although you lose money when the markets go down, bcos you put the same amt again after it has declined, you buy more of the stock/UT/index fund, and over time, since all markets will rise, you will earn the market average return of 8-10%.

However, one must be wary that it's also detrimental if you cut it too thinly ie if you DCA every mth, you end up paying a lot of commission bcos sometimes for UT there is a sales charge for every transaction, and for stocks the bid-ask or the $20 transaction cost kills you. This is what brokers will recommend bcos it generates more commission dollars, so beware!

I have 2 recommendation to improve on DCA that I hope will help most pple.

1) This is just reiteration. Don't cut it too thinly, ie maybe at least once a year and buy more at one go, like maybe roughly $10k at one go. Imagine if you DCA every mth at $1k. You pay 2% sales charge, or you pay $20 on transaction at the brokerage, which is also 2%, you are giving the return away, investment earn only 8%pa on average. So it has to be a huge amt to offset these costs. At $10k, the $20 becomes 0.2% + some bid-ask which ends up maybe like 0.8% or something. Alas, for UT or funds that charge 2%, too bad, $10k you still pay 2%. So avoid funds with huge sales charge.

2) Buy more when the markets are down. Instead of DCA-ing the same amt. You can buy more when markets are down ie. in 2000 you really DCA a minimum amt, 2001 you increase your DCA to 120%, 2002 to 140% of original, 2003 another increment etc. Of course, on hindsight, that's easy. We knew what happened already. How about now? Do you increase your DCA amt next year if the markets are down? Chances are if it goes down in 2008 it's gonna go down in 2009 as well right? But I guess one simply has to strengthen the will to increase DCA when the markets are down and lighten up when the markets are rally. That way, it will enhance return and help you hit 8-10%pa over the long run.

To Cut or Not To Cut

In Value Investing, you NEVER cut losses. If you have analysed the company and have determined that it is a good buy, and you bought it. If it goes down, you should be buying MORE of the stock. Since it is cheaper now. Well, that's provided everything is still the same since the time you did your analysis.

But for most novice investors, including this blogger, our analysis is usually flawed. There is probably something that we missed. Remember the market is not stupid. In fact we all know the saying don't we, "The market is always right." If you bought a stock, and it falls 20-30%, chances are something is wrong with the company, at least in the next few mths (well the market is very short-term focused also). And it pays to redo your analysis.

Well if you are willing to wait out the storm (which may take years), then all is well, it may go down 20-30%, but eventually it will come back, and it will surpass your cost price, in time. If you are a true blue value investor, and you think the co. fundamentals have not change when you decided to buy it back then, and if you got the GUTS, then BUY MORE of it.

For those not so true blue value investors, well you may want to follow some trading rules, ie to cut loss at a certain level. Some recommend 10%, some 15% below the price you bought, depending on how much pain you can endure. Hehe. But remember the tighter the cut loss level, the easier it gets triggered and the easier you get whipsawed. Btw whipsaw means you sell after the stock tanked 15% and then it goes to rally 100% and you go and bang your head on every wall you see.

Cutting loss is actually also rational in some ways bcos you can buy more of the stock at a cheaper price. If the stock is now $10 and you used $1000 to buy 100 shares. It drops to $5. And you use another $1000 to buy 200 shares. So you have 300 shares.

But if you cut loss when it drops to $8. You get back $800. It drops to $5 and you use the original $800 plus another $1200 you get to buy 400 shares! In both cases, you spend $2000 but if you cut loss and buy back at a lower price, you get more shares!

Having said that, it is not easy to cut loss bcos of the psychological factor. This is well studied in behaviour finance. People tend to hold on to their losses far longer than they should. And they take profits too early. Bcos if they cut loss, they have to admit they were wrong, realized their mistakes. But if they simply hold on, it's not realized, there is still HOPE that it will turn around. Vice versa, for profits, once they locked in, they would have proven a point, they got it right. And the right to brag about it later on. So pple always take profit too fast. It is in the wiring of our ape evolved minds. A seasoned investor tries to overcome this malfunction and makes the money.

On Technical Analysis or TA

One of the books recommended on this blog has this interesting story about technical analysis or TA. A professor ask a class of students to play a game. They are all given each a pencil, paper and a coin. They are to draw a stock chart with stock price at $1 starting from Day 1. Every toss of a coin represents how the stock will do for that day, and if it lands on head, the stock price goes up 3%, if it lands on tail, the stock price goes down 3%. And from there, they can plot the stock charts for 100 days (i.e. 100 tosses).

Guess what the resulting charts look like?

They look exactly like actual stock charts with famous patterns like head and shoulders (btw this is not a shampoo brand hor, this is a technical signal in stock charts), double tops, double bottoms, flag formation, cup formation etc.

Why is this so?

According to the professor, in the short run (short run means anything less than 10 yrs hor) stock prices move on positive and negative news, and news flow as such are random, like tossing a coin. Hence by looking at how the stock has moved in the past cannot help you predict what it will do in the future. On every new day, the stock has 50% chance of going up and 50% chance of going down, (like tossing a coin), depending on whether good or bad news will come out on that day. So how can you try to determine which way it will go by seeing what coin toss you have done in the past 10 or 20 days?

Then why is there all those studies about technical analysis, head and shoulders, double tops etc? To give them the benefit of the doubt. I think these things work a bit. They probably work 52% of the time and fail you 48% of the time. Btw these are quite good statistics bcos if you go casino it becomes more like 80:20, meaning 80% chance you will lose.

The main reasons why TA work are probably:

1) self fulfilling prophecy: people think that they work and then strive to make it happen, eg when you see a double bottom, you and 10,000 other TAcians buy the stock, of course it goes up.

2) human/investment crowd psychology does not change: this is the basis for TA as explained by TA textbooks, support and resistance levels are formed bcos investor crowd psychology dictates these levels until the next driver pushes the stocks to another paradigm.

But having said that, we must understand that stock markets are complex systems and hence TA can only help you win 52% of the time. There are times that TA can drive the stock prices, and there are times other information like macro outlook, earnings announcement, sentiments etc drive the stocks.

TA is only marginally useful in predicting short run stock peformance and not useful at all in predicting long term stock performance. On the other hand, value investing has zero use in predicting short run stock performance but gives you a little bit of an edge in predicting long term stock performance (probably 54% or so). The good thing about value investing is if you have done work homework, even if you are wrong, you will not lose your shirt.

See also Securitizing Taxis