Should I buy specific stocks or the indices?
Continued from this post:
I closed yesterday’s post in this Dow Theory blog by
asking whether one should just buy an index (i.e. IYT, DIA or SPY) or the
existence of a primary bull market warrants the acquisition of specific stocks.
This is a tough question.
My answer depends on what are
your goals and, more importantly the means to achieve them.
If you are happy with
outperforming the SPY by 3-4% a year over long periods (i.e 10 years) while
reducing risk (i.e draw downs when the going gets tough like in 2008-2009), then
you should stick to buying the indices. If you want to really outperform the
market, let’s say by 10% annual, then you must cherry pick your specific
stocks. However, this is easier said than done. I am not saying it cannot be
done, but here comes the issue of “means” I mentioned in the preceding
paragraph. I can confidently say that 99% of the investors lack the “means” or
tools or knowledge to select stocks that will outperform the market by 10% a year while
keeping losses contained. Such knowledge may be acquired but it times many years of focused effort and deliberate practice.
Furthermore, when buying the
individual issues (unless one buys all the components of an index) we don’t
know exactly at what level we have to place the particular stops for each stock
since normal chart patterns applicable to each stock are much weaker
technically than the stops placed under the Dow Theory. Nonetheless, if we buy
the IYT, DIA or SPY, we know precisely at what level they underwent the last
primary bear market low (concerning the first stop after the inception of a
primary bull market) or the lows of subsequent secondary reactions (concerning
successive stops as the market advances), and hence we can place the best
stops.
Furthermore, it gets more
complicated than this. Let’s assume that I am long the SPY and suddenly, the
SPY breaks the current stops fixed at the SPY lows of June 4. Should I sell out?
No, because such bearish action should be confirmed by at least one index. If
the DJIA or the Transports confirm, this is the signal to sell. Absent such confirmation you should hold your breath and wait. This shouldn’t
look bizarre to you. After all, in order to buy you demanded the existence of
confirmation. By the same token, you need a confirmed violation of
previous lows in order to sell out.
This principle of confirmation
works well when trading the indices (or their ETFs proxies). However, with
individual stocks, one never knows exactly where to place the stops. Should you
sell your stock in spite of its going up because the Dow Theory signaled a bear
market? Should you keep it and narrow stops? Should you stick with it? When
trading individual stocks things get more complicated.
I am not saying that you
cannot trade/invest in particular stocks according to the Dow Theory; however,
what I say is that you have to be very sophisticated when it comes to placing
your stops and choosing your investment candidates. Definitely, this is not a
task for beginners and even many professionals fail.
Problems compound because it
would be suicidal to just buy 2 or 3 stocks based on a Dow Theory bull market
signal. The investor should, at the very least, diversify into 10-15 stocks and
make sure that they are not too correlated.
I insist: The only rationale
for buying specific stocks instead of the indices is in order to outperform the
market. However, by merely following the Dow Theory and buying the indices, the
investor knows that long term 3-4% out performance is likely to be achieved
while losses will be kept to a minimum. Is this not enough for the average
investor? Investors should heed the wisdom of Charles Dow when he said 111 years ago (in 1901):
“If people
with either large or small capital would look upon trading in stocks as an
attempt to get 12 per cent per annum on their money instead of 50 per cent
weekly, they would come out a good deal better in the long run."
Nowadays, we have the possibility
(non-existent in recent years) to invest directly in the indices
through their ETFs proxies. So, why don’t we heed Dow’s advice?
Of course, and this is the
subject for a lengthy post or, better yet, for a new saga, the investor who
knows how to couple the Dow theory with particular stocks has a great potential
for outperforming the market, but also of losing his shirt in years like 2008
if he is not controlling risk properly. In life, everything comes at a price.
Personally, I wouldn’t allow
greed to prevail, and I’d keep it simple (which is not so simple after all if
we judge by the permanent strife between Dow Theorists and other technical
analysts, I included, who don’t seem to agree on whether we are in a bull or
bear market). If one can keep it masterfully
simple, one can expect to outperform the market by ca. 3 or even 4% annual
while avoiding the worst drawdowns (i.e. 2008) that the market always has in
store for us. If the average investor (and many professionals) can achieve this
long term, I can tell you is a remarkable feat.
Or put it another way: First,
become proficient in applying the Dow Theory to indices. Once you have proven
yourself that you are very good at it by making money (the only valid piece of
evidence) consistently (some years), then you may start to dabble with specific
stocks. Until then, you have to exert patience.
Well now this lengthy post is
ready. Those serious about its implications should carefully read it (and the
links pertaining thereto) as well as my disclaimer at the end of this post. I
am just writing my thoughts, and I hope to make you think. That’s all.
Sincerely,
The Dow Theorist.
Disclaimer:
Dow Theory Investment and its author is not a financial adviser. Dow Theory
Investment and its author does not offer recommendations or personal investment
advice to any specific person for any particular purpose. Please consult your
own investment adviser and do your own due diligence before making any
investment decisions. Please read the full disclaimer at the bottom of the
footer of this blog.
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