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Proven Triggers Trump Questionable Indicators In The Stock Market

A few years ago, in my role as a senior analyst with an Australian wealth management company, I was asked to accompany one of the senior advisers to a client meeting. This particular client, a reasonably wealthy couple in their 60's, would typically make their investment decisions only ever after joint discussion and on this particular day, it was only the husband who would be attending. Therefore, it was clear that no decisions would be made on this day but nevertheless, I wanted to impress upon him some of my findings from my recent research.

The meeting went well. The three of us enjoyed a healthy conversation and the client was certainly given food for thought. However, as expected, he confirmed that he was not in a position to make a decision because he would need to discuss things with his wife. It was at this point I asked him the process they typically used to make an investment decision.

His response shocked me.

He informed me that if they felt an investment idea was worth considering, then his wife would engage in astrology to reach a final decision. Quite honestly, I nearly fell off my chair. I couldn't believe that an investor could be so irresponsible.

When I told this story to fellow analysts and advisers, they all agreed too that it was utter nonsense. Imagine an astrologer appearing on CNBC attempting to persuade investors to sell their holdings based on the alignment of the stars. The vast majority would resort to ridicule.

However, this meeting got me thinking deeply of how the everyday retail investor decides on what to invest in. Many are influenced by what they learn through the media. For example, one of those celebrity-type economists arrives on the show and with an unnerving degree of confidence proceeds to expertly explain why the economy is struggling, why the Fed will need to print, why the US dollar is doomed and why gold is going to $5,000. Before you know it, the investor is in a ball of sweat and rushing to call his broker to buy gold.

I keep seeing these celebrity economists appearing in my email inbox, on my TV screen, in the newspapers etc. proclaiming to be the Nostradamus of finance. They will tell you how they predicted the lost decades in Japan, the Asian crisis in 1997, the dotcom bust in the 2000's, the Great Recession in 2007 and so on. What they omit is that they first of all predicted a whole host of other booms and busts that never materialized. They also fail to admit that in most cases their predictions were far too early, missing out on some incredible gains along the way.

Therefore, I pondered over the following question:

Is this investor that follows the forecasts of so-called experts any more responsible than the investor who makes investment decisions based on the alignment of the stars?

99% of people will say yes but the truth is probably no. The future is unknowable but not knowing is worrying. How often do you hear the traders in the pits explaining the reason for the market not going up being because the street hates uncertainty?

We accept these statements but the reality is these statements are just as nonsensical. Uncertainty is a fact. The sooner we admit to not knowing, the sooner we can devise our investment process around things that are happening rather than things that we believe are likely to happen.

Soon after this meeting with the client, I left my position in the investment industry in search of a better way to invest. I wanted to find a process that relied on proven indicators rather than questionable indicators. Big institutional players, due to their size, need to engage in the folly of forecasting. However, as an everyday investor, I realized that my size was my advantage and as such, being reactive rather than proactive would likely serve me well.

A Rule for Investors to Live & Die By

For those who have read Reminiscences of a Stock Operator based loosely on the legendary speculator, Jesse Livermore, you will be well aware of the importance he placed on sitting tight once he had made his move. In his reference to sitting, Livermore means allowing his winners to run. What follows is an excerpt from Chapter 5 of the book:

After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I've known many men who were right at exactly the right time, and began buying and selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine - that is, they made no real money out of it.

Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money. It is literally true that millions come easier to a trader after he knows how to trade than hundreds did in the days of his ignorance.

Livermore's second reference in the above passage relates to not always needing to be right in the market. Too many investors think that in order to be successful, you need to be right near to 100% of the time but this is a naive way of thinking. Identifying the opportunities to invest in is only the beginning. The second stage is the management of that investment whereby winners are left to compound but losers are cut quickly before their losses compound and impact the overall portfolio in a meaningful way. It is the management of the investment that delivers the real return on investment (NYSE:ROI).

A company that trades at a cheap price usually does so for a fundamental reason. Earnings are usually declining or have already declined and are depressed. Therefore, sometimes what we evaluate to be a fat pitch offering great value can instead be a value trap. The rule of cutting losers short enables an investor to quickly get out of what could prove a significant weight on the returns generated within the portfolio.

Again, in theory there doesn't seem to be anything too difficult about implementing this philosophy. Who wants to get in the way of a portfolio holding that first climbs 50%, then 100%, 500%, and beyond? And who on the other hand wants to watch their other portfolio investment fall 10%, then 20%, 50% and lower?

Well unfortunately, quite a few it seems.

One suggested cause is the confirmation bias investors suffer. That is to say, an investor focuses their attention on information that confirms their beliefs while at the same time disregarding alternative facts or occurrences. Therefore as the price of their investment declines, they remain rooted to the original evaluation of the prospects. In the world of finance and economics, where fresh data is updated regularly, confirmation bias is easily applied.

Not only has this bias been shown to contribute to poor decisions in finance, the same is true in military, political, and organizational contexts. Wishful thinking and the limited human capacity to process information are just two of the reasons put forward to explain confirmation bias. Therefore, investors need to take a leaf out of John Maynard Keynes, who quite simply proclaimed, "When the facts change, I change my mind. What do you do, sir?"

Another reason investors tend to hold onto losers (other than for tax purposes) is related to a bias called loss aversion. In 1979, Kahneman and Tversky presented an idea called prospect theory, which vividly illustrates the bias. They conducted a series of studies where their subjects answered questions on their appetite for risk and aversion to losses. For example:

1. You have $1,000 and you must pick one of the following:

a) 50% chance of getting $1,000 and a 50% chance of getting $0

b) 100% chance of getting $500

2. You have $2,000 and you must pick one of the following:

a) 50% chance of losing $1,000 and 50% chance of losing $0

b) 100% chance of losing $500

The logical answer for someone to give is either "a" or "b" for both questions. Someone that chooses "a" for both essentially has a 50% chance of walking away with $2,000 and a 50% chance of walking away with $1,000. Someone who chose "b" for both will walk away with a total of $1,500 regardless. However, what their study revealed is that most people chose "b" for question 1 and "a" for question 2. The conclusion drawn is that people are willing to settle for a reasonable level of gains, even if they have a chance of winning more (1.b). However, when it comes to the possibility of limiting their losses, they are willing to embrace a greater level of risk (2.a).

Needless to say, as logical and simple as the rule of letting winners run and cutting losers quickly is, it has its detractors. How long should you let winners run? What defines a winner and what defines a loser? When should you cut losers?

The answer to such questions is straightforward. You must include a trend trigger in your investment process

Valuations Indicate but Trends Trigger

The idea of following trends in the market is nothing new. Most are probably aware of Michael Covell who documented the approach in his book "Trend Following" and "Trend Commandments". AQR Capital Management released a paper in 2012 entitled "A Century of Evidence on Trend Following Investing" highlighting the stellar performance of time series momentum portfolios constructed across a combination of assets. Meanwhile, Mebane Faber of Cambria Asset Management excellently highlighted the simplicity of the approach in his white paper "A Quantitative Approach to Tactical Asset Allocation" and in his book "Stocks for the Long Run", Jeremy Siegel also highlights the evidence behind adopting a trend following strategy.

Despite the evidence, many investors are dismissive of adopting trend following as part of their investment criteria. I believe this is down to their misconception of how straight forward it actually is Fundamental investors switch off when they either see or hear some of the more exaggerated forms of technical analysis.

It was the French aristocrat Antoine de Saint Exupery who claimed that "Perfection is achieved, not when there is nothing left to add but when there is no longer anything left to take away". Investors would do well to heed such words of wisdom when it comes to investing in the stock market. To illustrate how straight forward but powerful a trend following strategy can be, I want review a price moving average crossover strategy. That is, a signal is triggered when the price of the market or security crosses above or below the moving average.

  1. Price crosses above moving average = Buy
  2. Price crosses below moving average = Sell

Furthermore, for those who might be concerned that trend following is time consuming, I am going to use monthly moving averages. Therefore, a trigger is only generated at the end of any given month meaning the time it takes the investor to follow such a strategy is 10 minutes maximum.

The following table illustrates the returns (ex-dividends, transaction costs, slippage etc.) beginning in 1929 and running through to the end of 2013.

As can observed, the returns using the price moving average cross over strategy outperform that of the traditional buy and hold approach in the S&P500. However, what should pique investor interest in particular are the winning percentages. Despite the winning percentage ranging from only 48-61%, the strategy outperforms because the average win exceeds considerably the average loss. This is precisely what Livermore refers to when he talks about not always needing to be right but to instead allow the winners to run and cutting the losers quickly.

The performance of the strategy is especially powerful during periods of subdued market returns. Consider the decade 2000-2009, which is documented below.

During this period, the market lost 24% of its value whereas each of the moving average periods highlighted above delivered positive gains. Even the use of the 6-month moving average, with a winning percentage of only 43% outperformed the S&P500.

Conclusion

Regardless of the deviations in each individual investor strategy, the goal should be to same: to identify and remove losing investments as soon as possible while allowing the winning positions to advance and compound returns. However, what the investment industry has failed to reveal to the retail investor for too long is that to find winning investments is not the difficult part. Even simple strategies such as the price moving average crossover can outperform the stock market.

Rather, the real difficulty has always been and will always be the challenge of managing one-self. We are our own worst enemies, succumbing to the noise that is aired through the media. In this digital age, we think that access to instant information puts us at an advantage when the reality is that it often causes analysis paralysis, panic buying/selling and so forth. Don't compete with the institutions at their own game. They are in the game of investing not to lose. We as individual investors are in to win and our size brings with it great advantages.

If you haven't already, take the time to develop your investment process and system. Once you find your proven triggers it is then a case of being patient and disciplined. Incidentally, this is precisely the point of my Value in Trends (ViT) approach.