May 31, 2010

Stock Market Wizard Lessons (Items 51-64)

51. Hope Is a Four-Letter Words Cook advises that if you ever find yourself saying, “I hope this position come back,” get out or reduce your size.

52. The Argument Against Diversification Diversification is often extolled as a virtue because it is an instrumental tool in reducing risk. This argument is valid insofar as it is generally unwise to risk all your assets on one or two equities, as opposed to spreading the investment across a broader number of diversified stocks. Beyond a certain minimum level, however, diversification may sometimes have negative consequences.

53. Caution Against Data Mining
If enough data is tested, patterns will arise simply by chance – even in random data. Data mining – letting the computer cycle through data, testing thousands or millions of input combinations in search of profitable patterns – will tend to generate trading models (systems) that look great but have no predictive power. Such hindsight analysis can entice the researcher to trade a worthless system.

54. Synergy and Marginal Indicators
Shaw mentioned that although the individual market inefficiencies his form has identified cannot be traded profitably on their own, they can be combined to identify profit opportunities. The general implication is that it is possible for technical or fundamental indicators that are marginal on their own to provide the basis for a much more reliable indicator when combined.

55. Past Superior Performance Is Only Relevant If the Same Conditions Are Expected to Prevail
It is important to understand why an investment (stock or fund) outperformed in the past. For example, in the late 1990s a number of the better performing funds owed their superior results to a strategy of buying the most highly capitalized stocks. As a result, the high-cap stocks were bid up to extremely high price / earnings ratios relative to the rest of the market. A new investor expecting these funds to continue to outperform in the future would, in effect, be making an investment bet that was dependent on high-cap stocks becoming even more overpriced relative to the rest of the market.

56. Popularity Can Destroy a Sound Approach
A classic example of this principle was provided by the 1980s experience with portfolio insurance (the systematic sale of stock index futures as the value of a stock portfolio declines in order to reduce risk exposure). In the early years of implementation, portfolio insurance provided a reasonable strategy for investors to limit losses in the events of market declines. As the strategy became more popular, however, it set the stage for its own destruction. By the time of the October 1987 crash, portfolio insurance was in wide usage, which contributed to the domino effect of price declines triggering portfolio insurance selling, which pushed prices still lower, causing more portfolio selling, and so on. It can even be argued that the mere knowledge if the existence of large portfolio insurance sell orders below the market was one of the reasons for the enormous magnitude of the October 19, 1987 decline.

57. Like a Coin, the Market Has Two Sides – but the Coin Is Unfair
Just as you can bet heads or tails on a coin, you can go long or short a stock. Unlike a normal coin, however, the odds for each side are not equal.

58. The Why of Short-Selling
With all the disadvantages of short selling, it would appear reasonable to conclude that it is foolhardy to ever go short. Reasonable, but wrong. The key to understanding the raison d'etre for short selling is to view these trades within the context of the total portfolio rather than as standalone transactions. With all their inherent disadvantages, short positions have one powerful attribute: they are inversely correlated to the rest of the portfolio (they will tend to make money when long holdings are losing and vice versa). This property makes short selling one of the most useful tools for reducing risk.

59. The One Indispensable Rule for Short Selling
Although short selling will tend to reduce portfolio risk, any individual short position is subject to losses far beyond the original capital commitment. Because of the theoretically unlimited risk in short positions, the one essential rule for short selling is: Define a specific plan for limiting losses and rigorously adhere to it.

60. Identifying Short-Selling Candidates (or Stocks to Avoid for Long-Only
Galante, whose total focus is on short selling, looks for the following red flags in finding potential shorts:

- High receivables (large outstanding billings for goods and services)

- Change in accountants
- High turnover in chief financial officers
- A company blaming short sellers for their stock's decline

- A company completely changing their core business to take advantage of a prevailing hot trend.
- The stocks flagged must meet three additional conditions to qualify for an actual short sale:
> Very high P/E ratio
> A catalyst that will make the stock vulnerable over the near term
> An uptrend that has stalled or reversed

61. Use Options to Express Specific Price Expectations
Prevailing option prices will reflect the assumption that price movements are random. If you have specific expectations about the relative probabilities of a stock's future price movements, then it will frequently be possible to define option trades that offer a higher profit potential (at an equivalent risk level) than buying the stock.

62. Sell Out-of-the-Money Puts in Stocks You Want to Buy

This is a technique used by Okumus that could be very useful to many investors but is probably utilized by very few. The idea is for an investor to sell puts at a strike price at which he would want to buy the stock anyway. This strategy will assure making some profit if the stock fails to decline to the intended buying point and will reduce the cost for the stock by the option premium received if it does reach the intended purchase price.

63. Wall Street Research Reports Will Tend to Be Biased

A number of traders mentioned the tendency for Wall Street research reports to be biased. Watson suggests the bias is a result of investment banking relationships—analysts will typically feel implicit pressure to issue buy ratings on companies that are clients of the firm, even if they don't particularly like the stock. Lauer, who was himself an analyst for many years, pointed out the pressure on analysts to issue recommendations that are easily saleable (popular, ultra liquid stocks), not necessarily those with the best return/risk prospects.

64. The Universality of Success

This chapter was intended to summarize the elements of successful trading and investing. I believe, however, that the same traits that lead to success in trading are also instrumental to success in any field. Virtually all the items listed, with the exception of those that are exclusively market specific, would be pertinent as a blueprint for success in any endeavor.

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