Category: Market Insights

There are two main concepts one needs to understand and maybe learn the hard way, before becoming consistently profitable:

1. Different setups work in different markets.

The same setup that can deliver outsized profits on one trading environment might lose you money in a different market. For example, buying strong stocks in hot industries in anticipation of a breakout works great during market uptrends, but it is a system with no edge at best during range-bound markets. Buying breakouts after a few days of a general market rally in a range-bound environment is not a profitable approach. Swing trading is a lot more challenging during corrective markets when correlations between stocks are very highs, volatility is ginormous and the market changes its direction frequently. Intra-day trading is a lot more profitable during fast corrective markets than during low-volatility steady market uptrends, when swing and position trading provide more lucrative alternatives.

Edges come and go because markets are constantly changing – sometimes, in a predictable, cyclical manner; other times, in a completely new and unexpected way. The path to survive and grow is to constantly experiment with new ways to make money and protect capital.

2. The concept of holding power.

Many novice market participants trade with too much size and get easily scared out of sound positions.

Holding power comes from two things:

a) A good entry – this means picking the right setup for the current market. A good entry helps to keep our potential loss small, while it provides the opportunity to make multiples of our initial risk. Risking a dollar to potentially make three dollars per share.

b) The right position size – I risk between 0.5% and 1% of my capital depending on the market.

Leverage and trading too big have ruined not one or two accounts. I became much better and consistently profitable trader once I cut my position size to reflect my current trading capital and the current market environment. Not all markets provide equal opportunities for profit. There are times to be aggressive. There are times to protect capital and confidence.

Most people (passive and active investors) don’t get average market returns. The market averages, the S & P 500s of the world, have actually achieved a lot better than average market returns.

Many passive investors achieve below average returns because they are over-diversified, receive bad advice, and pay high fees to financial advisors. Keep in mind, many financial advisors are not in the performance business. They are in the business of providing sound financial planning services. It is not something that you cannot do by yourself, but let’s face it – most people simply lack the knowledge, the desire or the time to do it. The question is how much is a good financial advisor worth? One percent of your capital every single year? On a 500k, this is 5k a year. There should not be a big difference between allocating 500k and 5 million to index funds. Why are financial advisors not charging a flat fee after a certain minimum capital requirement is met?

Most hedge funds are not able to achieve average market returns over a long period of time after fees. 2 and 20 or even 1 and 15 can be hard to overcome if you manage a substantial amount of capital. If it is practically impossible, why should investors even bother? Considering the much bigger risk that you are taking, the leap of hope, the tax implications, hedge funds and managed accounts’ benchmarks should be a lot higher than S & P 500, the Russell 2000, the Vanguard Emerging Markets Index Fund, the S & P Global 1200, etc. So don’t gloat if your fund managed to beat the market by 200 basis points last year. You need to deliver a lot more to justify the risk people are taking with you. How much more? I’d say 1.5X their usual benchmark. The worse case scenario should be average market returns after fees with a smaller drawdown than the market averages.

What about active traders? We should take into account not only our return on capital but also our return on time and efforts spent. The time we devote to trading is a time we cannot use to acquire other skills. Therefore, we should require from ourselves a lot bigger than market average returns. 2x, 3x, 4X than what a market average can do for us. If we cannot achieve them and statistics show the vast majority of traders and investors cannot, there are better options for our time, intellect and money.

The way I see it, you have the following options:

a) Dollar-cost average in a cheap, well-diversified index fund and never read another financial article or watch financial TV.

b) Find a reasonably priced financial advisor who can earn his keep by providing a personalised financial plan. This is a good option if you are already rich and your goal is to remain rich.

c) Find smaller money managers with a great track record after fees. It is not impossible. I personally know half a dozen smaller managed account managers that have done a good job.

d) You can pay for education, strategic direction and ideas. There are quite a few amazing trading and investing services out there that more than pay for themselves. You save time, gain skill, and improve your odds of achieving substantial returns by spending very little money.

Has it ever occurred to you that bubbles always happen in a new asset class that people don’t yet understand and have no idea how to value? Cryptocurrencies, Internet Stocks in the late 90s, Japanese debt, real estate and stocks in the 80s, gold in the late 1970s, Dutch tulips, etc.

Bubbles (trends) can last a lot longer than most can possibly imagine. They can be both wealth creators and wealth destroyers.

Recognising something is a potential bubble is not hard. Convincing yourself to participate in it is a lot more difficult.

Every bubble goes through three stages: first, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident by most people. Fear of missing out kicks in in stage three.

Every bubble needs sceptics and naysayers. Otherwise, there won’t be anyone left to buy. By the time most people feel it is safe to enter a trend, that trend is usually close to an end.

Here’s George Soros, explaining bubbles in a way more sophisticated manner:

First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, there is a lack of equilibrium conditions.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognise that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.