Chapter 5: How to Evaluate a Trading Strategy
Contents
Characteristics to look for in any investing system
Obviously, there are many strategies that can be used in stock investing, but there are certain characteristics to look for in any plan for investing. Before we can develop a strategy for investing, we need to have a set of criteria by which to judge if it is a good plan or not.
Building upon our previous discussions about common investor mistakes and stock-market myths, I offer the following eight criteria as the means by which to judge an investment plan – any investment plan. The degree to which a strategy stacks up well against these criteria determines its desirability. The very best strategies will satisfy the following eight requirements:
- Lets gains run their course, cuts losses short.
This is a necessary element for any good plan of investing, especially the part about letting gains run to their full potential. As long as a portfolio is well-diversified, you can probably afford to make the mistake of holding onto your losers, but you absolutely must not make the error of prematurely cashing in your winners. Since we expect our gains over long periods of time to exceed 100% of our initial investment, the amount of damage that can be done by cutting our winning stocks short far surpasses the damage we can do by failing to cut losses. However, for optimal performance it is best to both cut losses and ride winners as long as possible.Much has been written about what the ideal point is for cutting losses. Some say it is 10%, that is, that you should never lose more than 10% on a stock trade. Others say you should never lose more than 8%. I have found that cutting losses this short leads to excessive trading and excessive losses, and does not allow a good stock enough room for normal day-to-day fluctuations. When cutting losses to 8% or 10%, it is extremely easy to get bumped out of a stock only to have it recover and begin soaring again without your being on board.For this reason I prefer to take a radically different view of loss-cutting. I aim never to lose more than 3 % of my total account value on a single stock trade. As an example, I might set my stop-loss point back 30% from my purchase point and invest no more than 10% of my account’s assets into a single stock. Therefore, I will not sell the stock unless it gets into serious trouble and falls 30%. If the worst happens and the stock does lose 30% of its value, I will have lost only 3% of my account’s assets on the trade since I only invested 10% of my accounts assets into the stock. So, 10% times 30% equals 3%. I believe that this approach to loss-cutting is far superior to arbitrary rules which require cutting losses too short. If you can aim to lose no more than 3% of your cash on any one trade, it will take a long string of uninterrupted losers in order to seriously deplete your trading capital. Of course, there is nothing magical about the 3% number, but the point is to keep your possible losses from any one trade to a very small amount. Even in a market dip, it is improbable that all of your positions will drop to your sell point. - Gradual entry into major positions, as long as the position continues to be profitable.
It is inevitable that any system which attempts to let gains run will eventually build some large positions in a few stocks as the stocks grow in value. That is the good way to develop a large position. Also, it is OK to build a position by adding to the position as it advances in value; in fact, most professionals continually add to their stock holdings as the price moves in their favor. In this way, they maximize the potential reward for holding a particular stock or basket of stocks.However, some approaches cause an investor to plunge a large amount of his capital into and out of the market all at one time. This is the type of approach which must be avoided at all costs. It is risky to enter any market all at once because it maximizes your ability to lose a lot of money in a hurry. One poor timing decision can result in a loss of a large percentage of your capital, and these drawdowns in capital really hurt you. A 33% loss of your capital requires a 50% gain on the remaining capital just to get to the breakeven point. It is also unnecessary to take such daredevil risks because most trends last long enough that there is plenty of time to get on board and a lot of money can still be made by entering a trend in several installments as it is developing. - Mimimal chance of a large loss from any one position.
This is an adjunct to #2, as the gradual entry into a position is a means for minimizing the chance of loss from a single bad decision. Again, it cannot be emphasized too much that massive drawdowns in your capital are to be avoided at all costs. Any plan of attack should score well in the area of keeping our eggs in many baskets as opposed to one; and we should not have a large percentage of our assets in a single stock unless our average purchase price is far below the current market price. If we do well at that, we can sustain a large one-day drop in the price of a stock without losing much, if any, of our original investment. - Clear, predetermined criteria for initiating, adding to, or liquidating a position.
In the heat of battle when you are dealing with your hard-earned money, the instructions from your system must be as clear as crystal. If not, you will find yourself making judgment calls that relieve your short-term stress, and yet are poor long-term decisions. Precise and unambiguous signals and marching orders are the best way to head off the effects of euphoria and fear. You may still feel these emotions, but as long as your system is sound and you adhere to it fastidiously, everything will turn out well. - Sells a stock once it begins to underperform.
While we want to make sure we have a means for riding a stock’s trend for as long as it can go, when it becomes clear that the trend is beginning to profoundly weaken or even reverse, we need to have a system which allows for selling the stock so we can re-deploy capital to greener pastures. - Maximum dollars invested in biggest winners.
If a strategy allows us to build a large position in an issue that is lagging or even losing money for us, there is something seriously wrong with that strategy. The common complaint one hears from many stock market participants is that they wish they hadn’t invested so much in XYZ Company and they wish they had invested more in ABC Co. This mis-allocation of assets is usually accomplished via some of the common investor mistakes in Chapter 2, especially the mistakes of adding to a losing position, or plunging. A successful system needs to ensure that our biggest investments are in our best stocks, not in our worst. - Minimum dollars invested in losers/underperformers.
This is the converse of #7. It is interesting to note that the only ways you can accomplish having too much invested in a loser is to either plunge into it all at once and fail to cut your loss, or add to a losing position once it is established as a loser. Both of these are deadly mistakes and any system we develop must preclude us from commiting these sins. - Not time consuming to maintain.
This is important because throughout this book I assume that the reader’s time is his most valuable asset, and probably in short supply as well.
When an investment plan is not really a plan
Occasionally, one will hear statements such as “sell a stock once its earnings growth slows,” or “hold a stock as long as its product looks good.” Often, these types of statements are hawked as rules for investment. I want to make a point that these types of statements are not really plans at all, in and of themselves. They are far too subjective for the very tangible world of the stock market, where stocks are given a specific price every minute of every trading day. In order to be useful for decision-making by us mere mortals, the system used must tell the investor exactly when to buy or sell, and how much to buy or sell. How can you spot that precise moment when a company’s product turns from good to bad, or when a company’s earnings have “slowed?” Chances are, you can’t. Since a stock’s price generally reflects such events long before they actually happen, these subjective sorts of approaches tend to be a day late and a dollar short unless you are incredibly well-connected to the company in question. Even if you were well-connected, then you could be trading on inside information, which is against Federal law.
It is conceivable that if you could develop some non-subjective criteria about how to tell when a firm’s product or earnings are losing their edge, you might possibly be able to develop a true (non-subjective) system around it. Even if you could do it, it would be different for every industry, making it very time-consuming to implement. Therefore, this type of approach is not very practical for the average person and definitely violates our requirement that our strategy not be time-consuming to maintain. There is a difference between subjective rules of thumb for trading, and a non-subjective system for trading. Learn to recognize the difference and you will be several steps ahead of the majority of investors.
Five Minute Investing Course
Introduction
Chapter 1: Replacing Our Stock Market Myths
Chapter 2: Things to Avoid
Chapter 3: Know Yourself
Chapter 4: Stock Picking
Chapter 5: How to Evaluate a Trading Strategy
Chapter 6: The World’s Worst Trading Strategy
Chapter 7: The Reverse Scale Strategy
Chapter 8: Margin Power
Chapter 9: Implementing the Reverse Scale Strategy
Chapter 10: Getting Started