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Here are 3 Ways to Stay Profitable Forever

Tuesday, May 31, 2011 | Chris Rowe

Every Tuesday (the day I write for The Tycoon Report), before the article, I will list one or two "test your knowledge" technical analysis questions and after the article I'll list the answers.  I hope you find this fun and I hope it helps you make more trading profits.  Sometimes small bites can have a huge impact.

Technical Analysis Question of the week:

Which momentum indicator am I describing?

This indicator compares the strength of the price action of a security to its own historic price action.  This indicator gives overbought Sell and oversold Buy signals, oscillating between 0 & 100.  As is the case with nearly all indicators, you can use any number of time periods to adjust the indicator to work with the time frame that you are studying.  Below is the calculation:


******

~ This exercise is pretty much guaranteed to make you a much more profitable trader or investor over time.

I know some pretty savvy traders, mainly in NYC and Chicago, but all over the globe. 

I was visiting a major brokerage house recently where they recruit traders who are "up and coming."  What they do is they let the multitude of new traders, using their technology, trade their own money while the hottest traders in the house teach the newbies how to become better at their craft.  Then, they take a small handful of the traders that obviously have the most skills, and they hire them as traders for the firm, using the firm's capital. 

What struck me as most interesting was when the CEO of the firm told me, "Y'know Chris, what we like to do here is train traders fresh out of school.  We don't like training the traders who have been trading for over a decade.  The reason why: it's too difficult to unlearn the bad habits they already have instilled in their system."

WOW!

This is a firm with real money on the line (remember, they will cherry pick the best traders -- trading with their personal money -- to eventually let them trade the firm's money!).  And they don't want the veterans?

It's very difficult, and even painful, to deprogram yourself and unlearn bad habits.  It can be like changing your diet.  But the results are just as rewarding!

So one of the very first things I am doing as I create new trading classes for Tycoon U is I'm putting together a system for unlearning bad habits. 

Let's go over a few of the very basic bad habits you might need to unlearn to become a great trader and consistently outperform the general market.  I can't possibly overstate the importance of this process, as 90% of trading profitably is simply managing your own emotions and avoiding reacting in a way that you as a human being are genetically programed to. 

The high level of difficulty in going against human nature is actually a huge benefit to you as a trader because it gives you an immediate edge over those whose trading decisions actually move markets. 

Why? 

The biggest and savviest fund managers in the world also experience the same flaw that anyone does, as they, too, are human beings.  If you can fight human nature, you can win most of the time.

I can't cover all the most common bad habits here, and that's a good thing for those who will REALLY use this article as an exercise, because you don't want to try to break too many bad habits at the same time. 

"They" say it takes 30 days to make or break a habit.  So let's chew on a few today and perhaps you can focus intensely for the next 30-days on breaking them. 

Before deciding to give up because you think you don't stand a fighting chance against institutional savvy investors, let me tell you why you have an edge over them. 

Studies show that since professional investors/traders are more confident, they perform much worse than they might have if they weren't as confident about their ability to make money in the market.  The two most common biases among professional traders are over-optimism and overconfidence.


Bad Habit #1 - Overconfidence

Avoid overconfidence at all costs.  Avoid the dangerous cycle that most traders repeat over and over again: The one where they become more and more confident as they become "hot" and then inevitably get SMASHED.  They become humbled by the market and hopefully still have money to invest, which makes them better traders, and the cycle repeats itself. 

This may be the hardest to break, so I focus on it first.

How do you break this one?  You already have a head start if you're not a professional. 

Overconfidence is particularly pronounced among experts as opposed to lay people.  One study found that 68% of analysts thought they were above average at forecasting earnings.  75% of fund managers think they are above average at their jobs.

Studies done by "Dunning and colleagues" show that the absolute worst performers are generally the most overconfident.  They say those that are overconfident "suffer a double curse of being unskilled and unaware of it."  They are too confident about their ability to predict and typically have the "illusion of knowledge" driving that overconfidence.  

Basically, the skills that are needed to produce correct responses are almost identical to skills needed "to self-evaluate the potential accuracy of responses.  Hence the problem."

Forecasters continue to forecast even after overwhelming evidence that they aren't good at it, which can be explained as ignorance (not knowing the overconfidence exists) and arrogance ("ego defense mechanism"). 

So stay humble and avoid the cycle which will surely end up humbling you anyway (the stage that comes after overconfidence).

Look at the chart below.  In a study by Torngren and Montgomery, two groups of participants, lay people and professionals, were asked to choose which stock was going to outperform each month.  The laypeople were undergrads in psychology and the professional investors were portfolio managers, analysts and brokers. 

They would chose between two stocks (well known blue chip names).  They were all given the name, the industry and previous 12 months performance for each stock.

(Study Source: DrKW Macro research)

The students were 59% confident in their stock picking abilities on average and the professionals averaged 65% confidence.  Obviously the lay people outperformed the professionals by a large margin. 

When the professionals were 100% sure they were correct, they were actually right less than 15% of the time!  Look below at how, as the "perfect calibration" line (confidence level) moves up, performance declined -- dramatically for the professionals.  Also notice how lay people never said they were 100% confident.


(Study Source: DrKW Macro research)

You might think these studies are flawed or that I'm cherry picking the studies, but I have tons of research on this with a number of other studies that show the same thing.  The point is you don't want to be overly confident when positioning yourself. 

It's always important to know what the indicators that you're following actually mean, to get as good of a grip on market action as possible.  But no matter what, always remain humble and avoid the cycle described above, and avoid having an ego at all costs. 

It's no wonder 85% - 90% of fund managers underperform the market.

And what is "The Market" anyway?  Not what most people think ...


Bad Habit #2 - Talking and Thinking in Terms of The Dow-30

Quick!  What's "the market doing" right now?  You have 10 seconds to answer.   Really see if you can do this.  Check to see what the market is doing.  I'll wait ...

You probably just quoted the amount by which the Dow Jones Industrial Average is up or down.  Most people will say, for example, "the market" is up 100 points!

NO!  You want to get away from that immediately.  You might be saying "But Chris, the major financial news networks always tell us what the market's doing by quoting the Dow."  EXACTLY!  They are part of the problem.  They have to give you bite sized bits of info for two reasons. 

1.  Time limitations.  They aren't going to sit there and tell you what small-caps or mid-caps are doing.  Heck, they aren't even really telling you what large-caps are doing.  They are mainly telling you what mega-caps are doing.  They know you have limited time and you want EVERYTHING.  You want to have your cake and eat it too by getting market info without spending real time getting it.  

2.  Confusion = lower ratings.  The last thing they want to do is give you what some perceive to be too much info.  If they tell you what each group is doing, they will turn people off and then the network will be turned off when you change the channel. 

So we are programmed to think about "the market" as the Dow-30.  But they are really just 30 multinational and mostly mega-cap, blue chips.  They can trade up 1% while 70% of the stocks in the market are up 10%.

It's important to break the habit of thinking of "the market" as the Dow Jones Industrial Average.  You can't be profitable in the stock market unless you become the minority.  

If I told you the S&P 600 small-caps index is up 37 points, would that mean anything to you?  Anything at all?

Because if it is up 37 points, it means the major small-cap index is up 10% on the day!!

If you break the habit of quoting the Dow-30, and start viewing the market as small-caps, mid-caps, large-caps and mega-caps, you'll start to see the market more clearly than ever ... you'll start to see trends forming faster than the majority of those who follow the market and before the end of this year ... you'll start to become more profitable!

At least that's the kind of improvement reported to me by just about everyone I gave this advice to over the years that reported back.  I invite you to do the same.  

So for the next 30-days STOP QUOTING THE DOW!  

When someone asks you what the market did today, say: "The market is up 1.5% - 3%, depending on the index you're talking about."  Even ask them what part of the market they are asking about.  If they look at you funny, or even laugh at you, you'll know you're on the right path.  You can then ask them in the future if they know what's been in favor lately, the small-caps, mid-caps or large caps. 

The key is to feel comfortable with being in the minority.  Why should you be ignorant just because almost everyone else is?

Plug the following symbols into your tracking list right now:
  • S&P 500 (large-caps): Symbol SPX, $SPX or ^SPX depending on the system you use.  
  • S&P 400 (mid-caps): Symbol MID, $MID or ^MID. 
  • S&P 600 (small-caps): Symbol SML, $SML or ^SML. 

You should also plug the next group of symbols into your tracking list:
  • The Russell 3,000:  Symbol RUA, $RUA or ^RUA.  This index has 3,000 of the largest U.S. stocks that represent 98% of the publicly traded market.  You might think this will give you the best picture of the entire publicly traded universe.  However, the index is heavily weighted towards the large-cap universe.  You'll see what I mean below.
  • The Russell 2,000 (small-caps):  Symbol RUT, $RUT or ^RUT.  This index is made up of the bottom 2,000 stocks in the Russell 3,000.  While this index makes up 2/3 of the Russell 3,000, this index only represents about 10% the market capitalization of the Russell 3,000 (or about 10% of the entire market).  Keep in mind while this is the benchmark most small-cap funds use, it's actually made up of several mid-cap stocks too. 
  • The Russell 1,000 (large-caps):  Symbol RUI, $RUI or ^RUI.  You may have guessed already that this makes up 90% of the market capitalization of the Russell 3,000.
  • The Russell 800 (mid-caps):  Symbol RMC, $RMC and ^RMC.  This represents the bottom 800 stocks which make up about 1/3 the market-capitalization of the Russell 1,000.
  • The Russell 200 and the Russell top 50 (mega-caps):  These both represent mega-cap stocks.  I follow the Russell top 50 - Symbol RTF, $RTF or ^RTF.  This is the top 50 largest market capitalized stocks representing about 40% of the market-cap of all U.S. stocks. 
After focusing equally on small, mid, large & mega-caps for 30-days (and that means really comparing the performance of each daily and and viewing the charts of each weekly) you can move on to dividing each of the above indices into growth and value.  You can start here for the Russell Indices, and then Google S&P small-cap value, S&P small-cap growth, S&P mid-cap value etc. to find information and symbols on each.

At this point you may be asking:  "Chris, how on earth can I be expected to follow so many different indices?  How can I keep track?  It's so overwhelming!"

ANSWER:  If you're like the average U.S. citizen, you can quickly name at least 40 of the 50 states, or 20 of the 32 NFL teams, or 20 of the 30 NBA teams.  Heck, you might even be able to give the stats of each team or even their strengths and weaknesses.  How many sports players are you familiar with?  I can give 10 more examples, but you get the point.  

Become familiar with these indices bit by bit and, over time, it will become second nature. 

If you do this, you will spot trends and reversals much faster, you will see the market much more clearly, and if you're like most of the people I gave this advice to over the years (who reported back to me) you will find yourself to be a much better trader/investor by the end of this year!

When you decide you want to be a black belt, start viewing the market in terms of sectors.  We all know that stocks within the same sector act in unison.  They mostly move at the same time like schools of fish.  We know one sector can advance 20% while, in the same time frame, another can decline by 30%.  

So if you want a true picture of how the market is performing, start viewing the market in sectors.  Here's a link to the image below showing S&P sector performance (they merge telecommunications with technology).


To start, you can begin watching the 10 S&P sectors.  But if you want to be a true Jedi, start focusing on the 46 Sector Hunter sectors!  Again, remember my sports analogy.  Anything you have interest in, you'll have an easy time following.  And believe me, when you do these recommended exercises, you'll be psyched about how clearly you're seeing the market or how much better your performance is!


Bad Habit #3 - Talking About Positions or Trading in Groups

Don't do it!

It's incredibly important to have the ability to NOT stick to your guns, but to be willing and able to change your market stance, because markets are always evolving.  When you talk about the positions you've taken, you're psychologically reinforcing your stance, thus making it more difficult to change that stance as needed. 

Realizing you've made a bad decision is a lot easier when you know a bunch of other people did the same thing, right?  WRONG!  Your mind is playing tricks on you.  You're almost guaranteeing bad performance if you make group decisions about your market posture or trading moves.  Many bad decisions made by investors are the result of group interaction. 

If we already know that in order to outperform the market we have to be the minority, and that if we want to lose money in the market we should think like the majority, then we know group decisions are a bad idea.  You would only be making it more likely that you do what the majority is doing!

This is true unless, of course, your group decides to make the trades that the minority thinks it should make.  But obviously that's not how it works -- the group will do what the majority thinks it should do. 

It's Technical Analysis 101 to know how to use investor Sentiment readings as contrary indicators!  I mean traders literally trade off of the fact that the large majority of investors are thinking the same way -- and are almost always wrong!

You don't have to be part of an investment club to be in this bad habit.  Most people have this habit because it's impossible to look around the web to find your data and information on stocks or ETFs without stumbling upon other investors' opinions.  And most of those investors are names of those you know to be smart investors. 

But it IS possible to pull the information you need and to leave the rest. 

I don't want to overload you with too many assignments of bad habits to break.  Trying to break too many at the same time will just be too difficult, and Rome wasn't built in a day. 

But I'll leave you with this final thought about taking advice from others. 

The charts below all use data from the Federal Reserve Bank of Philadelphia Livingston survey or the Survey of professional forecasters. 

The first one shows economists' attempts to forecast the rate of inflation as measured by the GDP deflator.  As DrKW macro research points out, economists are really good at telling you what just happened.


Below you can see the same thing when it comes to market analysts forecasting the stock market's next move.  The forecast of trend changes are always long after they actually occurred.  In fact, the analysts, on average, are always late to the game.



The same thing is true when it comes to forecasting earnings: 



I'm considering writing pieces like this once per month.  Sort of a 30-day assignment each month for breaking bad habits.  You can only do this with repetition and, while it may seem easy, it's hard to be very strict with this sort of thing because your bad habits are ingrained in your system. 

But you'll realize superior returns if you focus on these three habits, hard core, for the next 30-days.  Please leave your comments below telling me if you're going to do this.  Will you make the commitment?  Are you up for the challenge?

Leave your comments, and therefore your user name, and check back in 30-days to tell me how it improved your perspective.  It will take some time to improve your trading, but first thing's first. 

Until next Tuesday!

******
 
Answer (to TA question from above the article):

The "RSI", or Relative Strength Index (not to be confused with comparative relative strength, which compares one security to another), measures the relative strength of a security against itself.

In other words, it compares the current price action of a security to its historic (usually recent) price action, indicating whether the momentum is strengthening or weakening.

Here is a link to a Tycoon Report article I wrote on the indicator: "How to Sell at the Right Time"
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Chris Rowe
Chief Investment Officer
Technical Analysis Millionaire
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