What's Luck Got To Do With It: More Than You Think
What does luck have to do with making money in the stock market? There are only two possible answers to that question: Everything or Nothing.
I've been trading stocks for over 35 years. The best trades of my stock market career have been more luck than anything else. The same can be the worst trades of my life. No matter what methodology I had adopted at the time, fundamental analysis, technical analysis, insider buying and selling, IPO's, Elliott waves, astrology (yes, astrology, don't knock it if you haven't tried it) or CNBC gurus, some of my trades turned out to be blockbusters, others slammed my accounts to the ground with a foot pressing hard against my throat. The common denominator at the time of winning, or losing, was always some methodology I had embraced that depended more on luck than brains. I just didn't realize it. How could that method be so right at times, and so wrong at others?
Luck - An Unheralded Role In Profits and Ego
I once bought a small cap penny biotech for 40c. I studied its science, knew management, talked to members of the scientific advisory board and basically did my homework, I knew this company like the back of my hand. One year later it was selling at $13.25 and I was master of the universe. I had found the Holy Grail: Due diligence and biotechnology penny stocks. Of the next four of these gems I bought, two went out of business and the other two were down 80% in a matter of weeks. That was it for me, penny biotechnology stocks, and most of my previous winnings. What went wrong? How could one of these penny stocks do so well and the others almost bankrupt my trading account? Hint: It wasn't my due diligence. I was lucky on one, and unlucky on the other four. On the winner, I confused hard work for dumb luck. I blamed the losers, on, "crooked short-sellers," when it was simply my naive overconfidence and a lot of bad, bad luck. In these cases, luck had everything to do with my success and failure. I was just a conduit who placed the trades, leaving my money as nothing more than a bet on a roulette wheel, letting the spin of wheel, with neither my brains, efforts, nor methodology have any say in the matter.
My experience with the biotechnology stocks exemplifies the carnage left in the wake of luck having so much influence in successful market bets. Think about the best trades of your life and ask yourself if you made it happen, or, if you were just in the right stock at the right time. This is not something new, luck has been disguised as skill in investing for so long as there have been gurus, and coin tosses. It has just gone unrecognized in the complicated investor psychology world of ego and denial. It is a costly misdirection no matter how overrated or invisible one's level of investment acumen.
This phenomenon of mistaking investing luck for skill infects every inch of the investment business, from investment banks to mutual funds to financial media to individual investors. It is also probably responsible for more losses and bankruptcies than any other market force since the dawn of time. No matter how carefully or how often the concept is explained, no matter how much evidence is provided to back it up, most people just can't accept that their investing success probably has more to do with luck than skill.
Blodget, Henry "Smart? Skillful? Probably Just Lucky"; Slate, 2004
How Trend Following Trumps Luck
I've been wiped out a few times in my stock market career. Each time I got up off the ground, dusted myself off, realized what it was I had just done wrong, learned from it, and started anew. It's been ten years now since I was KO'd by the market and I attribute it all to embracing trend following as my vehicle of choice to navigate the ups and downs of stock market investment. Trend following absolutely minimizes the effect of luck on my trading. The thing about trend following is that there is no guesswork involved and it is the demon of guesswork that opens the door to luck determining your success in the market. However, even in trend following luck is hovering around, but's role is so diminished that it has almost zero effect. There is no guesswork when you buy a stock that is going up, or sell a stock that is going down. There are no predictions involved, save one assumption: The trend in place today will most likely be in place tomorrow. That leaves only one needed observation: What is the trend today?
If you are very lucky, the trend being observed today is near the beginning of the trend and if you are very unlucky, the trend you are observing is nearing its end. But both of those extremes are outliers as trends, by their very nature, are not often at either extreme, neither at their beginnings, nor at their ends. The vast majority of trends are ongoing. Trade enough trends and yes, you will get in at the wrong time,i.e., at the very end, but you are just as likely to get in close to the start of new trends. Those two extremes instances should ultimately cancel each other out and for the most of your investing in trends you will be getting in somewhere closer to the middle, with lots of room to run until the trend eventually comes to an end.
The Two-Second Investment System
Trend Following is how I minimize my need to be lucky in my trading. Note I didn't say "eliminate" because there is no way to eliminate how luck will affect results. Buying stocks that are rising in trends and selling stocks that are falling in trends is about as basic an investment strategy as can be implemented and there is only one component to the technique: Recognizing the trend.
In 1999 I contributed a chapter to a book titled, Confirmatory Analysis: Finding Winning Stocks. Mine was the only chapter based upon trend following and the truth is that the rest of the book, mired down in convoluted applications of various fundamental concepts to picking stocks, never made any sense to me. It was hard to read, harder yet to understand. (Sorry fellow authors, please don't sue me.) In it I set out my "Two-Second Stock Picking System." Here it is for free, no need to buy the book:
(1) Print out as many stock charts as you want, any stock or sector of stocks that you believe has the potential of landing in your investment or trading account;
(2) Procure a stop watch;
(3) Procure a friend to hold the stop watch;
(4) Now put all of the printed out charts in a single pile, back sides up;
(5) One-by one turn over the charts and give yourself 2 seconds and 2 seconds ONLY to look at the chart, observe the trend (if any) and say out loud "Up" "Down" "I can't tell".
(A) If you say "Up," have your friend put chart in a new pile designated as "Up"
(B) If you say "Down," have him/her put chart into a second pile designated as "Down"
(C) If you say, "I can't tell," throw the chart on the floor.
After going through all of the charts you are left with two piles, Up or Down (and if you did it right, a bunch of charts scattered on the floor.)
(6) Go long any and all of the stocks in the Up pile;
(7) Sell or sell short any of the stocks in the Down pile;
(8) Sweep up and toss away all of the charts lying on the floor.
What have you just done? You have used your intuitive sense to figure out if a stock is in an uptrend, downtrend, or as you will find true in most cases, going sideways. As the late, great Marty Zwieg stressed, "The trend is your friend." You now have put together a portfolio of stocks that are going up and more aggressive traders have a selection of stocks going down to short. You have also put together a portfolio that has minimized the effect of luck on your investment success. In so doing maybe you had a little fun, versus the typical angst involved in stock selection. Repeat the exercise periodically, maybe once a month to monitor your holdings and to identify any stocks that are reversing trend. In fact, do it right now to every stock you are holding, no matter what rationalization you have, or has been fed to you, for holding it.
Among the myriad of investment gurus and systems, the Two-Second System puts you in charge of your investment destiny, not some stranger selling you services, software, training classes and certainly not relying solely on erratic and unpredictable dumb luck.
SPY & Gold: Spot The Trend And Win The Prize
Pick any place along the continuums of the trends below and apply the Two Second Investment System to the price trend. At different places on each chart, cover up the right side and apply the test. How many times did you get it right and do so without luck having anything to say about it?
(Try not to cheat. Of course you already know the answer by seeing the charts that are sitting right below but run the test anyway, as true to the rules as possible, it's your money that is at stake).
Are You Kidding Me, Two-Seconds?
Three if you live in California.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have Long positions in SPY and Short poisons in Gold. See charts.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.