Saturday, March 29, 2008

How To Make Money In Stocks Part 4: Keeping It Simple 3 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
"Complexity is not a cause of confusion. It is a result of it." This is a saying by Anonymous, the best I could find and the best reflection of my views. In the wake of the subprime crisis that all unanimously agree has arisen from the quantitative complexities of derivatives like CDOs and CDO-squared that baffle CEOs from proper risk management, mesmerise institional funds into blindly buying, and confuse regulators into despairing acquiescence, I think many more people would start to appreciate the beauty of simplicity. Or was that last 55-word sentence a bit hard to swallow as well?

The pinnacle of achieving simplicity will be the ability to reduce stock market behaviour and strategies to a series of equations that can be consistently applied to make money, but as I understand no academic has been able to achieve it yet (though nobody who's done it would really want to make it public). But in the absence of such a Unified Theory of the Global Stock Market, it'll be good to develop a few mental frameworks to facilitate one's assessment of the overall market and the various sectors and how they will develop in the foreseaable future: a sort of guide on the direction of change, since absolute valuation is obviously not viable. In short, develop a framework to integrate various fundamental developments and then translate them into a sector- and stock-picking strategy that will best ride on your simplified reading of the future.

The idea of simplicity ties in with my views on mental focus. Without reducing the everyday noise to a series of indicators to focus on, decision-making can be fragmented and lack conviction. In fact, everyone can have different frameworks for decision-making (which is why I shall not try to impose any of mine here) and still succeed because there're so many roads to Rome ie. so many different ways of making money in the stock market. I was reading a book on trend-following where traders like John W. Henry and Richard Dennis basically used one simple decision-making tool to trade: the price. Their belief is that the price reflects the public and hidden fundamentals. It is deceptively simple and yet they make great money because they understand the risks of this framework, and cut loss promptly when wrong. This is an example of one-reason decision-making (they just need a single piece of information for making a decision); the academic term is "fast and frugal heuristics", where one employs a minimum of time, knowledge and information to make adaptive choices in real environments. This is an example of simplicity at its barest bones.

What I plan to write on more in this article is actually what NOT to do. I believe that if one learns to avoid the bad things, the good stuff will naturally come (that's partly the reason for my HotStocksNot blog). Many people tend to venture into areas where retail investors with shallow pockets face no competitive strengths, partly out of curiosity, and for the more enterprising --- out of desire for more knowledge and to maximise profits. But it is easy to entangle oneself in complexities that favour more well-equipped professionals, and diworsify one's mental focus. My "one-audience" view is that therefore, it's best to avoid when in doubt, though there might be exceptions. Below are some of these "complicating" ventures that can prove stumbling-blocks:

1) Foreign markets. It is tempting to buy overseas stocks, especially the temptation to associate oneself with the brand names that one hears about all the time (say, Apple). But one is most likely to buy into the liquid overseas stocks where there is no discovery premium and potential gains are likely to be compressed (efficient market), simply because he has limited research facilities on these overseas stocks as well as probably high trading costs. There are a myriad of other issues, such as the fact that domestic investors are likely to be more protected in times of trouble. So, what for? Outsource it to professional unit trusts, with research facilities and administrative clout, in this aspect.

2) Derivative instruments. They are highly quantitative, and more than once have surprised punters with their behaviour (eg. puts that go down when markets drop). Their time decay aspects are often overlooked as people often only look at the underlying asset aspect, with the result that one can often be fundamentally correct on the underlying asset while still losing money due to unfavourable short-term movements. It is an example of layering complexity on complexity: one needs to be sure about the underlying asset short-term characteristics, and then be sure of the derivative pricing quantitatives.

3) Leverage. Use it sparingly and only when you have strong conviction and strict cut-loss rules. If you feel your competitive strength is in understanding the true long-term strength of the company, why complicate it by applying leverage and implictly betting that (a) this long-term strength will be recognised in the short-term and (b) your buy-in timing is spot-on and that the stock will not do a correction before reversing back upward?

4) Short-selling. This stems from a desire to take advantage of market downtrend ie. to continue to make consistent profits even as the market turns. In other words, it has a tendency to stem from greed. Again, leverage is involved, and one needs to understand the calculation of margin. For short-selling, if the position moves against you, it can be a double hit on the margin because numerator (equity) declines while denominator (total asset market value) rises (as opposed to buying on margin where while numerator declines, denominator will also decline). Always understand the risks and work out the possibilities.

Within the Singapore stock market and within the simple buy-and-sell approach, there are already so many possibilites. Why make life more complicated? Those seeking to "learn new things" should go back to school. Those looking to generate new conversation topics (by taking up new instruments) should attend cooking classes. Those looking for excitement should wait for the casinos to open.




Anonymous Anonymous said...

not sure I agree with your points on leverage. Margin provides a buffer against the fact that your cash flow may not be sufficient to maximise the opportunities caused by sudden market plunges (as has been the case in past months). Think it is more a question of cash management (eg do not over-leverage) rather than using leverage per se.

My view on leverage is that it is merely a long term bet that the return from the stock will be at least (target growth rate+6%) annually

4/01/2008 10:56 PM  
Blogger DanielXX said...

The ability to use leverage is important and it differs for different people. I'm writing more for a retail audience and generally speaking my view is that one should not be too aggressive because as we have seen, things can always get from bad to worse, in an unexpected manner (eg. market falls when overseas market rises, or even on good news). As always, the use of short-term credit to reap long-term gains always has the dangers, and while some will still use margin to magnify their rewards, the best indicator is the sleep index: the amount of leverage that is enough to keep you awake at night is too much leverage.

4/02/2008 2:21 AM  
Anonymous Anonymous said...

I do not agree with your views here...especially your last few statements. The cooking class remark was targetless: innovation is vital in the financial world and should be encouraged..... So was the school remark: the last place to learn new things about finance is school. The newest things in school are theories on valuation methods and risk statistics, all utilized to create models based on the bell curve! To me, these “normal distribution” assumptions are what you refer to: “perception becomes fundamentals which further reinforces perception.”
The problem with innovation in finance is that all the new instruments that have been able to distance themselves from the simplistic-normal-distribution-school-of-thought and are able to see beyond the risk management fallacies, are so few that become mainstream so quickly and aggressively which overwhelm the market and distorts the life-cycle of the product. When first introduced to the market they quickly achieve to consistently make money but the specs are quickly made public with no regulation...this overelevates the profit levels making them so profitable that in-turn becomes so popular that it reduces its effectiveness. Hence, because of the market “transperancy”, this new-found inefficiency is quickly made aware in the market....and rumors take a life of their own.....crashing the system.
This is why I believe that in finance, the usefulness of innovation, ironically, lies in adequate regulation. Any new financial instrument should only be exercised by few participants in the market place; hence driving the “outsiders” to new ideas and more innovation rather than merely following others..

4/07/2008 8:51 PM  

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