Tuesday, June 5, 2007

A Consistent Approach

Another good question posted on the Yahoo Group asked "Should your strategy be consistently applied or vary depending on your overall stock market outlook?"

The following is an excerpt of the discussion that followed.

I prefer a consistent approach. I have no idea what the market, or any stock, is going to do in the short term, and don't believe anyone else does either. Therefore, I don't trust my own market outlook, let alone anyone else's. So, if I can't trust my outlook, why would I want to vary my strategy based on it? I designed my strategy to work regardless of market conditions. At least that was my plan. Whether or not it will work in all markets only time will tell. So far I've only traded my strategy in a bull market, where throwing darts at a stock list probably could have been profitable ;-) So, until the next bear market comes along I won't know how my strategy will perform. I do know that I've survived stocks that have declined substantially, so I believe I could survive a bear market, but until it actually happens I won't know for sure. In the meantime, I'll continue to consistently apply my strategy. If it ain't broke, don't fix it ;-)

The only belief we can have in any individual stock or the market in general, is that it can and will do anything at anytime. We can not presume to know what the market will do today, tomorrow or in the future. Now, this doesn't mean I don't have any opinions. Of course I have an opinion on each company I invest in and on the overall market, but I designed my strategy to be market and company neutral, just in case my opinion is wrong.

Positions that meet my criteria will profit in 4 out of 5 cases (assuming I sold ITM):

1. If the stock stays the same.
2. If the stock goes up a little.
3. If the stock goes up a lot.
4. If the stock goes down a little.
5. If the stock goes down a lot.

The only case where I lose is #5, if the stock declines substantially. However, since I only invest in solid companies using a value investing approach, I just manage those positions until they can be closed at a profit. So, I have yet to take a loss.

I have confidence in my trading plan and my ability to follow it, not in my ability to pick winners or in my short term market outlook. I do believe that over the long term the market will rise, because it always has, but I have no idea what the market, or any stock, will do in the short term.

That's why I never try to pick a direction. I don't buy stocks for my CC portfolio because I think they will rise. I buy stocks because the underlying company is solid and it meets my criteria for a CC position that profits in 4 out of 5 cases. It's the 4 out of 5 chances to make money on an ITM CC position that drives the success, not the prediction of direction. I have no idea how each position will work out but I like the odds.

Now, I didn't always think this way. For many years I studied and used technical analysis, which attempts to determine direction from past price action. I studied Elliot Wave, regression channels, Bollinger Bands, MACD, Stochastics, Relative Strength, etc., etc. Too many indicators and chart patterns to mention.

I've always heard the saying "past performance does not guarantee future results", however, when you see a pattern on a stock chart, whether it's there or not (research studies have shown that people see patterns where they don't exist. It's just the way our brains are wired), you believe that it will repeat. So many who follow technical analysis to pick direction believe in their outlook. I used to believe in my outlook also, but my results told a different story. I learned the hard way that nobody can predict, with any degree of certainty, what a stock or the market will do at any given point in time, regardless of how much analysis you do. The future is unpredictable.

Now I no longer try to determine direction, of a stock or the market, and no longer use technical analysis. Instead, I use fundamental analysis and value investing principles to analyze the company. My main concern, when choosing stocks for my CC portfolio, is whether or not the company will survive, not what its stock price will do, which is why I only invest in solid companies. My CC positions are such that I profit from little or no movement of the stock price. Even if the stock goes down substantially, I have confidence the company will survive and that its stock price will eventually rise. But even if it doesn't rise, I have confidence in my trading plan and my ability to manage the position to eventually exit at a profit.

In essence I've evolved over time as an investor to find the approach that works best for me. Investing is an evolutionary process. I've tried, and failed, with many different approaches until I finally found what works for me. It's a personal journey and everyone will travel a different road. Those who are willing to change and evolve will eventually be successful, assuming they don't lose all their money along the way.