OK. I admit it.
If there was one simple, powerful way of succeeding in the markets… that all investors could simply set up and start using right away… I would have told you by now.
But there isn’t.
There is no one secret to succeeding in the markets, just as there isn’t one secret to business success, happiness or health. It depends on your strengths, outlook and goals.
Which, by the way, is my answer to the most common question I receive from readers, which is: “Why do you offer so much (often competing) advice?” There is no one answer. There is no one secret. If there was, our business wouldn’t exist!
There are plenty of ways of succeeding in the markets. Much of it depends on you. For instance, this week I’ve been preparing our research on two completely different methods of investing, both of which have lots of evidence to support them, but that seem to be completely at odds with one another.
How can that be? How can they both work so well if they’re contradictory? That’s what I’m going to try and explain today. I’ll throw the floor open to you to judge whether I succeed.
It’s all in the mind
Let’s start with an intuitive way to trade the financial markets, developed by Eoin Treacy. At its core is a simple idea: data doesn’t move markets, people do. People aren’t rational. We’re emotional and act on instinct. Therefore trading the markets successfully is a matter of understanding behavioural psychology.
Eoin has developed a framework for figuring out how the psychology of the market manifests itself in a chart. He’s been trading it himself for ten years. (By the way, the reason I’ve been working on it this week is because Eoin and I have been putting a free online training program together. It’ll be available in early March. If you’re a trader, or want to be, look out for it.)
In a private discussion with our staff earlier in the year, he talked about how he slowly discarded all the “normal” technical indicators traders use in favour of his own, psychology-based ones. In that sense, you’ve probably never seen anything like his strategy – it’s not an automated system relying on indicators flashing buy or sell, as many trading strategies are.
Or to put it another way, he’s not trading numbers, he’s trading people’s reactions. Charts are just an expression of those reactions.
Let me give you an example
Eoin’s framework for a new trade involves three elements: a range, a story and a trigger.
A range is a charting pattern with a specific psychological mindset. It involves the market trending sideways between an upper limit and lower limit, bouncing slowly off each and not going anywhere. It involves a period of deteriorating expectations. People get bored and start to expect the market to drift sideways, reinforcing the range.
Ultimately, all ranges break out – they start a trend either up or down. These moves are explosive. But they do not happen by accident. It takes a powerful psychological shift. That’s where the story and trigger come in.
Take the Dow Jones Industrial Average before Donald Trump was elected. It had drifted sideways for over a year. Donald Trump became a “story” – a potential reason for the market to head higher. He became a narrative people could start to invest some thought and feeling into: “Trump might not win, but if he did he’d increase spending and cut regulation, which would be inflationary and good for the financial markets.”
That’s the story
It developed over months. The markets didn’t break out though. It took the trigger to lend urgency and instinctive reaction to the story. In this case it was Trump’s election. That was the catalyst that made people act on the story. The markets broke out. We’re still in the middle of that rally.
Here’s the interesting part though. We still don’t really know exactly what Trump will actually do.
He’s made a lot of promises. So do all politicians. But not all politicians have the effects on the market Trump has had. What’s different is the markets’ perception of what he’ll do. That’s what’s moving the market. It’s not real, hard data. It is behavioural psychology.
That’s what Eoin is looking for: moments when the psychology of the crowd shifts around a specific event and moves the market.
To some, that’s too short term and risky. To others, it’s a revelation: the forces that govern the moves of the market aren’t hidden technical indicators, they’re buried in our own minds. Trading them can be extremely profitable. More on that from Eoin coming up soon.
Psychology vs value
As I said, some people don’t like that idea though. They prefer to invest using hard facts and unarguable data, not the slippery emotional, instinctive reactions of the crowd.
If you’re one of them, you’ve probably sat the Trump rally out, waiting until we get some concrete information on what he’ll do and what that will precisely mean for the bottom lines of real businesses.
That’s where value investors like Tim Price sit. As methods of investing go, it’s at the exact other end of the spectrum. The idea is to simply focus on the price of a company, and the “value” of it – often what you’d get if you wound up the company today. If you can buy £1 worth of assets for 60p, you buy. Then you wait.
The principle is easy to understand. The market is not perfect. It doesn’t always price things efficiently (because markets, like humans, aren’t rational). Therefore you can buy assets for far less than their intrinsic value.
You might have to wait for a long time, though. You’re waiting for the market to recognise the pricing error and bid the price of a firm back up to where it “should” be.
But the market can stay irrational longer than you can stay solvent
In short, you’re waiting for a return to rationality (where perhaps Eoin’s strategy could be described as anticipating and profiting from irrational behaviour).
Here’s the thing about value investing. When you analyse the track records of value investors going back half a century… the returns are absolutely mind-blowing. The potential for long-term wealth creation is undeniable.
But the short-term chances of you being dead wrong are also pretty good. In fact, a Research Affiliates paper published in January proved that – despite the long-term advantages of the approach – taking a pure value investing approach was most likely to get a fund manager fired! What works… is what gets you fired. Pick the bones out of that one.
The point, of course, is that fund managers are like football managers. They may talk long term, but they’re mostly judged annually. On an annual basis… the incredible benefits of value investing aren’t apparent.
Two different approaches. Two very different ways of investing and succeeding. You’re going to hear a lot more about both in the coming months. Which one suits your situation? Let me know at [email protected].
Until next time,
Nick O’Connor
Associate Publisher, Capital & Conflict
Category: Economics