Of course, you’ll also do the inverse, which is selling greed.
You’re still looking at price action. With trend following, you look for a certain indicator which says, “Okay, now the price is trending up.” With mean reversion, you look for price action to tell you a stock is oversold, so that it’s becoming cheap. (With short selling, it’s vice versa.) Perhaps the stock has been moving down for the last four days, 15 percent or more. The simple price action rule, if tested and proven, might be, “If I buy every stock that over the last four days has dropped 15 percent or more in value, then there is a statistically larger than random chance that it will revert back to its mean. Therefore, if I trade this strategy consistently, I’ll make significant profits in the long term.” That means you have an edge, and we only trade when we have a statistically proven edge. Generally, mean reversion is shorter term and is buying fear, or the opposite, selling greed.
As you can see, combining strategies ensures that we’ll make money regardless of how the market is performing. We do this because virtually no one can predict what the market will do with reasonable accuracy. We take that variable out of the equation, depending only on our proven strategies, rather than the unpredictable whims of the market. We accept that picking stocks is only for geniuses like Warren Buffett who devote their life to it, and build a computer program around our deficiencies as humans. Humans are good at many things, but in this case, it’s smart to let a computer do all of the grunt work. We aren’t fortune-tellers, and we can’t crunch numbers like computers.
Often, people have long-only or open positions, so when the market turns sour, they freak out. Everything on TV and online is bad, scary news, and they can’t help but react. People are basing their decisions on what other people tell them is fundamentally good, and then they get anxious about their positions. Of course, you don’t need to listen to the news if you have an automated strategy that is prepared for any market type—bull, bear, or sideways! Your task is simply to follow your strategy, because it is designed to make money in all market types. The news becomes irrelevant.
Imagine a scenario like 1929-1932, when your account would have dipped lower by the day. The Dow Jones and S&P 500 lost more than 80 percent of their value! If a time like that ever happens again, you’ll be grateful that you’re trading both long and short, and not exposing yourself to those losses. By designing a strategy that works well in both up and down markets, you’ve won the game. Your mental state will never be affected by inevitable downturns in the market. You can finally relax, as your money increases long term.
Investing is my life’s work, and I’m still often wrong in my personal predictions. For example, after the big bear market in 2008, around March 2009, many people were still writing that the world was going to end, like in 1929. They said it would go down another 30 percent. I actually agreed with that opinion, thinking the worst wasn’t over. But when you least expected it, and there was extreme fear, the market started to rise again. People’s logical thoughts and beliefs said one thing, but the price of the market said exactly the opposite. The prices are all that matter.
If I had followed my beliefs and opinions like most people do, I would have lost money. But I trusted my strategy, which ignores my personal predictions in favor of my suite of noncorrelated strategies. My bull strategies were already in place and trading, and I made money. By automating things and removing your opinions and beliefs from the equation, you make money even in the common instance that the market doesn’t make sense to you. The stock market is wholly unpredictable, so we plan around that, and make money regardless of what happens. We don’t hope to be right; we defer to the unpredictability of the market. What we’re doing is lowering our expectations but winding up with a better result. We’re ignoring our natural cockiness and ego, being rational instead, and profiting in the end.
Now, how do you create your own, personalized strategy? As I’ve explained, you base it on your beliefs, but not your predictions. The difference is that beliefs are ideas that can be back tested against historical price action; they are beliefs about what the market historically does when it is performing a certain way. Predictions are different and are based on evaluating individual companies, rather than reacting to the entire market on a broad level. It’s nearly impossible to predict individual stocks, because they are so dependent on market sentiment. It is entirely possible, however, to understand what current market conditions mean for all stocks, when calculations are automated to a powerful computer.
However, not all strategies are the same. Your strategy needs to be tailored to your unique situation. You do the work beforehand (which I’ll describe in depth in part 3) to reflect yourself in your strategy. You start with the core market concepts I have explained and will continue to explain: trading long and short at the same time, and trading both trend following and mean reversion. Therefore, you’re covered regardless of what the market does. You don’t need to predict what the market will do, because you’re covered in all scenarios. Within that framework, though, you will define your own personal beliefs and preferences. Then you trade according to your strategy, responding to the market’s price action, rather than riskily predicting it.
If your beliefs are different than mine, your strategy will look different. But as long as you have a clear understanding of core market principles, both of our strategies will work. For example, my suite of twelve noncorrelated strategies doesn’t work for people who have IRA or 401K accounts, because those restrict you from trading short. The solution would be to set your beliefs as long-trading biased. You are mildly limited, but it would still be possible to make good money. The only difference would be that there will be times when your strategy is out of the market and flat, because your indicators are telling you it’s currently a bear market. While my strategy would be making money, you would be flat. However, you would make more money in bull markets, because you aren’t paying the insurance hedge of a short strategy.
(There are some options to work with buying inverse exchange-traded funds [ETFs] and thus having a hedge, but the structure of those products are often misleading, so you need to be careful.)
Once your strategy is created, you don’t need to look at the news at all. Fed numbers came out? You don’t care. Company reports, yearly profits, blah, blah, blah—you not only don’t care about it, but you actively ignore it, spending time on things that enrich your life. You’re simply following your strategy, which tells you when and what to enter and exit. You just follow what price action is telling your strategy to do. The computer does all of the work and tells you when to buy and sell.
It’s no problem to trade three or four strategies at the same time. In fact, I trade up to twelve strategies simultaneously. This would be impossible to do without a computer, but my years of programming and testing thoughts and beliefs are now reflected in my automated strategy. Now, the analysis takes just a click on the computer. And because I only use end-of-day data, I can do my analysis in less than thirty minutes a day, and so can you. You can do it from anywhere in the world, because the only thing you need to do is wait until the market has closed, download your data, scan for the new trade setups, and then open your broker platform and make sure that before the market opens again, you enter the trades.
You can do this without any emotion clouding your judgment, because your task is not to be smart and pick the right stocks. It’s nearly impossible to outsmart the market. Your task is to follow the strategy, which anyone can do. You don’t care what the market is doing, because you have strategies in place to profit regardless of how it performs, no matter of how unexpected.
Most people lose money when they let their emotions get the best of them. As humans, we can’t be levelheaded and rational all the time, especially while losing money. For that reason, you program your risk tolerance into your strategy. The maximum money you can stomach losing is predetermined. Your strategy will tell you to stop trading at that threshold. Many people build a goo
d strategy, but as soon as it goes down 5 percent or 10 percent, they freak out, lose trust, and make bad decisions. If you define your maximum drawdown beforehand, you’ll stay calm and collected. You’ll be prepared for the worst, and you’ll know exactly what the worst is.
For example, you may predefine that you’re unwilling to lose more than 20 percent of your equity. When you compare that to the max drawdown of the S&P 500 (over 50 percent), that’s not a large number. I define risk tolerance as your maximum drawdown. Someone may say losing 20 percent of their balance isn’t a problem, but that answer isn’t usually based on experience. I work with people to visualize this loss vividly, to check the accuracy of their answer. “You say you’re OK with a 20 percent drawdown, but let’s say your $1 million trading account is down to $800,000. Are you OK with losing $200,000?”
If you haven’t visualized this potential loss, clearly defining the point where you will lose hope for long-term recovery, you’ll override your strategy as soon as the inevitable downturn hits. That will end in catastrophe. You need to trust in your strategy’s ability to recover, long term. If you’ve analyzed yourself enough to know what you can truly handle (and I’ll explain how), then you’ll know that big drawdowns are part of the game. You won’t panic, because you know you need to risk money and lose it temporarily to make money long term. Yes, you’ll make money consistently, in up and down markets, but there will still be times when the market is so bad that even with a perfect strategy, you’ll lose money. You’ll lose less than fundamental traders and virtually everyone, but you’ll still lose. You need to be able to stomach losses and trust your strategy’s long-term, scientifically proven results.
Now, what do you have to do before creating your own strategy to achieve financial independence in thirty minutes a day? First, you need to take serious time to analyze yourself, so you deeply understand your personality, preferred lifestyle, and trading beliefs and preferences. You may not like shorting stocks, for example. That’s fine, but if you don’t account for that when creating your strategy, you’ll have trouble following your computer’s orders, and you’ll fail. You need to be honest with yourself and make sure you’ll follow your strategy. You can only trade according to your beliefs. Those beliefs must reflect sound, proven market principles, but they also must suit your individuality. There are plenty of sound principles, so not everyone needs to trade the same strategies.
For example, if you are impatient, trend following is going to be difficult to follow. You will have long positions that will last for two or three months without profit. You wait a long time, see no results, then make a big profit. It’s effective, but boring. Impatient people will get bored and exit too soon. The profits don’t come quickly enough. There’s not enough action. You might believe in trend following, but your beliefs also must mesh with your personality, or it will be a disaster.
If you’re following mean reversion, you must be able to ignore the news completely. I never watch the news. The principles for mean reversion are buy fear and sell greed. If you watch the news, it’s difficult not to be influenced by experts shouting. You need to buy when there is a lot of panic in the market. You go against the herd and the shouting. That is not for everybody, nor is the opposite (selling greed). Mean reversion is the opposite of trend following, where you follow the whims of everyone. If you’re not comfortable ignoring mainstream opinion and going against the herd, you’re going to struggle trading mean reversion.
It’s also key to incorporate your preferred lifestyle into your strategy. If you want a life where you only need to watch the market thirty minutes a day, there’s a strategy for that, like the one I use. If you only want to watch the markets once a week, there’s a different strategy. If you only want to watch the markets once a month, there’s a strategy for that. If you love activity and want to make ten to fifty trades a day, there’s a strategy for that. I have students with busy jobs, traveling around the world as big-time executives, and they don’t even have time for those thirty daily minutes. But they incorporate that into their strategies, and do great. Each strategy works as long as it is clearly defined beforehand, so it will be followed precisely, with no trouble, doubt, or panic.
You put in the hard work beforehand to create a strategy and set of rules that you know you can follow, long term, and then you simply follow them and profit. As long as you’re honest and diligent up front, you’ll have tremendous success. The only way to fail is to fail to be honest with yourself.
Before we continue, it’s important to understand what we’re up against. Financial institutions will tout their performance versus the benchmark, often the S&P 500, but more than 80 percent of institutional traders fail to beat it. That is mainly due to commissions, fees. Here’s a visual look at the S&P’s performance since 1995.
As you can see, the benchmark has been far from impressive, with an average compound annual growth rate (CAGR) of 7.37 percent, a maximum drawdown of 56 percent, and two large drawdowns that lasted over five years. If you had started at an equity high like in 2000 or 2007, you would have entered in a drawdown, and waited over five years to get back to the breakeven point. Not good.
Since 2009, the benchmark (and stock indices in general) has done well, so buy-and-hold approaches have worked. This is a problem, because it causes people to look at the recent future and forget the past. The next big downturn, like 2000, 2002, or 2008, is just a matter of time. It will happen, at some point, so we need a strategy in place to survive.
Looking at the previous chart, it’s obvious that buying a mutual fund that tracks or closely correlates to the index is unwise, because you will lose half of your equity when the downturn hits. What if you started with a million dollars, and now you’re suddenly at $500,000? Will you still trust that your money comes back?
In the following chapter, I’ll show you how to set up simple strategies, based on fundamentally correct trading principles, following simple indicators. My purpose isn’t to show you how smart or great I am. My purpose is to show you that beating the market can be simple, if you know what you’re doing and ignore mainstream financial advice.
If you turn on the TV or read the news, you can’t help but think that investing is treacherous and time-consuming, and that you need to hire an expert to manage your accounts. Daily financial media throws complicated numbers at you, so wealth managers swoop in and promise to hold your hand and make you money. They say, “If you don’t know the earning reports and insider numbers, you’ll never pick the best stocks to hold long term. You don’t have the time, information, or expertise, so hire an expert!” It’s overwhelming, disempowering, and confusing.
It’s also complete nonsense.
Most people hire wealth managers via the typical, fee-based advisor system. But this system is designed to make them money, through your commissions. It’s not designed to maximize benefits for you, individual investors.
You hire a big firm, and they charge you a yearly fee to control your investments. They also charge you transaction fees for when they buy and sell your stocks and tweak your portfolio, plus performance fees.
They virtually all use the same strategy: buy and hold. Pick stocks, and stick with them, long term. Their goal is to beat the market indices, like the S&P 500. They mostly use what is called fundamental analysis. They look at a bunch of numbers, like earnings reports, and guess where each particular stock is headed. There is no clear exit strategy, nor is there scientific evidence that buy and hold works. Big firms justify their logic by saying, “The market always goes up in the long run.” But as anyone who has witnessed the market’s multiple crashes knows, the market inevitably sees big drops, and it doesn’t always recover.
This was exactly the case in both 1929 and 2008, and the results were disastrous. The 1929 crash led to a bear market that continued until 1932. As shown in the following chart, if we assume that people started to invest at the equity high (~380), they would have seen a drawdown of 88 percent, and it would have take
n twenty-five years for them to fully recover their losses. Of course, most people wouldn’t have the patience to wait twenty-five years. When people see big drawdowns, they generally run away from their advisors and quit trading for at least five to ten years, holding their extreme losses.
When you don’t have a complete strategy that prepares for bad times, your emotional state will dictate your decisions. In bad times, you’ll liquidate your portfolio at the worst possible time, and be forced to live with your losses forever. You’ll sell, not based on a strategic decision, but rather by the sight of your bleak bank account. This happens to almost every trader. It happened to me, before I woke up and realized I needed to prepare for these inevitable bad times. The solution is an automated strategy that trades both long and short simultaneously. Without a clear strategy in place beforehand, drawdowns are impossible to recover from, because you’ll liquidate before the market goes back up.
When the markets go down (and they always will), your portfolio, if you’re invested in a buy-and-hold strategy, goes down with it. Also, since big firms have so many clients, they can’t advise on lower-volume stocks. Trading lower-volume stocks with a massive client base would impact the market and evaporate any edge. They’re forced to only recommend large companies, which means their model loses just as much as the general industries.
Also, they only make money when you have money in the market.
When the market crashed in 2008, and the S&P was down 56 percent, the firms kept your money in the market, as your balance tanked. If they had taken your money out, as a smart investor would have done, they wouldn’t have received any commissions. The firms are controlling your money, but have different incentives than you. Would you give your car keys to a fast driver who would bill you for any damages he inflicted?
The 30-Minute Stock Trader Page 4