Monday, December 10, 2012

Don’t fall in love with your stocks! Love is always dangerous

How to develop confidence in the Dow Theory

Today I read two good posts that highlight the importance of not falling in love with your stocks.

In the “Systematic Relative Strength” blog, there is an interesting post concerning the risk of loving one stock. Please click here.

In the “Big Picture” blog, there is another good post in which it is written:

“We have learned the hard way never to fall in love with a position.”

Many years ago, I had to do with the real estate business. I saw firsthand that, in spite of competent advice, people fall in love with houses that don't warrant their price. But love blinded the buyers and, all caveats notwithstanding they fell into the trap.

The same, and even to a larger extent, happens with stocks and investments in general. Be it because we hold one company in high regard: “It is a wonderful company with excellent products and great management” or merely because it is not pleasing to our ego to be proven wrong, we still to rationalize our sticking to our stock holdings.

Of course, the admonition to all investors is: “Don’t fall in love with your investments."

However, this is easier said than done. It is much easier to buy than to sell. And when it comes to selling, it is very difficult to pull the trigger.

Here is where technical analysis, and more specifically, the Dow Theory, helps the investor detach his investment decisions from his emotions/ego. While following the signals displayed by the Dow Theory require a good deal of discipline, it is, in my opinion, easier to foster discipline based on a technical system that, by definition, is not based in “love” or “liking” of one company but in objective measurements.

Of course, many will object that it is not so easy to have the discipline to stick to a technical system. This is true when the investor has just a superficial knowledge of his technical system. When tried by the markets, he will throw the towel and follow his guts instead of the system.

However, there is a fire-sure way of building discipline. You cannot have discipline if you don’t have faith, deep faith in the system. Be a “true believer” and you will not have any problem with discipline. The issue is one of confidence. However, your confidence must be a rational, well grounded, one.

In my humble opinion, it takes two requirements:

1)     You must know your technical system inside out. You must understand why it works. You must understand the psychological forces that shape the patterns you see in the charts. Thus, under Dow Theory, the principle of confirmation, is not a whimsical requirement that just happened to work, but it is anchored in a sound aprioristic principle, namely that if stocks are going to go higher long term, the rising tide should lift all boats eventually. Thus, pure empiricism is not enough to foster confidence (and with it disciple). Aprioristically your system has to make sense and be grounded in reality. Do the rules make sense? As far as the Dow Theory is concerned, all of its rules make aprioristically sense. They are just not happenstances. Of course, to understand the valid aprioristic assumptions of the Dow Theory, it is a must to read the original writings of Charles Dow and his colorful explanations of how market participants shape with their actions and tactics the patterns we see reflected in the charts. Again, there is no substitute for hard work.

However, even the best aprioristic rules have to pass the test of reality. By this I mean that performance must support the assumptions made. In other words, empirically the system has to be proven right. Here, again, the Dow Theory excels, and its real-life  track record is excellent.

2)     You must have a sufficient number of observations to be sure that your good results are not just a fluke. Here is where many systems (or patterns) fail. I would never invest or trade a system without a well-established number of observations. While I am aware that the past cannot predict the future (and hence the importance of being endowed with solid aprioristically knowledge of your rules which give you trust in the repeatability of your patterns), the higher the number of observations and the longer the years (and market conditions) the system had to live through, the better. Once again, the Dow Theory, and specially the Rhea/Schannep persuasion, shines. I think the Dow Theory is the only investing method with demonstrable observations dating back from 1900. Such time spans many investment environments and lends credibility to the system. Furthermore, if one uses the “Rhea/Schannep” “flavor” with an average duration of trades of ca. 1-2 years (depending on the specific flavor and market condition), one derives one added advantage. Which one? Think it over….

By aligning oneself with the cyclical bull and bear markets (instead of the secular trend) one has a much larger number of observations (trades) which lends more credibility to the system. If you invest along the secular trend, by definition, you will not have more than 10 “trades” if we define a secular trend as lasting up to 14 years (as Schaefer did). While we can discuss about the “quality” of such 10 trades, personally, I’d feel uneasy committing my capital in trades that may exceed 10 years when only 10 observations are available to me. I know that Schaefer despised “systems” and, accordingly, he derided the “Rhea” flavor of the Dow Theory. Anyhow, I feel more comfortable knowing that the “Rhea/Schannep” flavor possesses a track record of +50 observations. +112 years, in all kinds of market environments, and +50 observations, give me a high degree of confidence.

Of course, once you have such theoretical, aprioristic, knowledge of the Dow Theory, and you couple it with a long track record, your confidence soars. Once you have confidence, discipline to stick to the Dow Theory becomes an afterthought. I am convinced that weak discipline is a mere reflection of low confidence.

Once you have the discipline to stick to the Dow Theory or any other system for that matter, the risk of falling in love with your investments is greatly diminished. When the technical system screams “sell” you will sell; no questions asked. Therefore, I think it is much safer to your capital to fall in love with the Dow Theory than to fall in love with any specific stocks. Be monogamous and just fall in love with the Dow Theory; don't be promiscuous by falling in love with stocks.


The Dow Theorist

No comments:

Post a Comment