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Monday, May 28th, 2007

Why I missed the recent big rally in the stock market, part II - 5 lessons learnt

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In part I of this article I told how I botched the last seven months and missed the big rally by being disorganized and too bearish.

I’ve learnt a few lessons:

1. Minimize or plan for disruptions

One of the main reasons I didn’t do well in the past seven months is because I was moving countries and getting married. It was a disruptive phase. I lacked internet access for a month in London before leaving, then another month after arriving in Australia.

Conventional wisdom says you shouldn’t trade during major disruptions in your life. That’s true if your wife is having a child or there is a serious illness. But in my case it was simply poor planning. If you’re serious about trading you have to be around to take trades and play out your edge. Being sidelined for two months is unacceptable. I should have made better arrangements to have internet access.

2. Don’t be too bearish on the stock market

I made another mistake by being too negative on the market. It is easy to become bearish after the market has made big gains. It is normal to think things can’t get better.

But look at the historical performance of the market. It suggests being bullish more often than bearish. The US stock market surged 1,500,000 per cent from 1900 to 2001, according to the book The Triumph of the Optimists. There were only 25 down years in the past 100 years or so. While corrections are normal, fully fledged bear markets are rare. If you’re bearish more than three to four times in two decades then you’re overdoing it, Ken Fisher says in his book The Only Three Questions that Count.

If you want equity-like returns, you have to be in equities more often than not. I’m not saying don’t plan for bear markets or have a bear strategy (I certainly do), but your system should be designed to keep you in the market most of the time.

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3. Delete — not add — indicators and variables to your trading system

Another problem I had was adding new variables to my trading system, including monetary indicators. I also incorporated elements of Dow Theory, which called on owning fewer equities during the last speculative phase of a bull market.

Adding indicators or variables to your system inhibits your ability to make decisions. It’s even worse if they are qualitative or vague.

For example, how did I tell if we were in a speculative phase of the bull market? I started looking for anecdotal evidence. It appeared the general public were entering the market (a bearish sign) because more people were talking about stocks. It’s natural to start getting worried the market’s gone too far after good gains. I can assure you it’s not too difficult to find evidence to be bearish. I believed the bull run was over every time a person I knew talked about the market.

I only started making money trading after reading Mark Douglas’ book Trading in the Zone. It forced me to cut my system to as few indicators as possible. As Douglas says, one of the keys to trading is to objectively identify your edge.

Your trading system should consist of a few well-tested indicators. They will give a clear, concise message that your edge is present or not. If you add more indicators you will become confused, begin to doubt, and miss crucial trades.

4. Be careful who you read

I’m always reading about the market, including books, blogs, internet sites etc. You have to be careful about how they influence you. Be particularly wary of constantly bearish bloggers and columnists.

As Gary B Smith once wrote, read about trading out of interest, but don’t let it affect your market stance. Your system alone should tell you whether to be bullish or bearish.

5. Avoid taking cash from your trading account

I made another mistake by taking funds out of my trading account for personal use. I thought it was fine but it can be devastating psychologically. Taking money from my account seemed to cloud my mind and for some reason threw me off course.

Fund short-term cash needs using a credit card. This may not make sense economically if you’re paying a higher rate of interest than you’re earning from shares in the market. But it will have less impact psychologically. Your trading account should be sacred.
 
 
 

 

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Word Count: 707. This entry was posted on Monday, May 28th, 2007 at 10:44 am and is filed under Investing psychology, Market direction. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.