Using “systems” to reduce risk and improve investing performance.
Using a system to manage your finances is critical and most often extraordinarily worthwhile – in terms of reduced stress and reduced losses. Being organized just makes you feel better and in control. I contend that your finances and your health rank as the top two areas of your life that are most important to your well-being. I will let the doctors help you with the latter concern. The last blog post I promised to address this topic, so follow along here.
Money management should be treated somewhat much different than most other work-a-day fields of study, as there are various roads to success (and failure). One size does not fit all. The landscape and markets change and force us to change along with them. Using a system should allow you to assess your track record if followed with discipline, to know why it did or did not work, and then to fine-tune it for better success.
So what are some ‘systems’ used? Two for today bear mention, and we'll dwell on technical systems. We’ll stick within the category of stocks since that’s the most popular vehicle for investing now-a-days.
The two broad types or categories of systems are FUNDAMENTAL and TECHNICAL. The difference? Fundamental systems deal with company-specific operational data such as earnings, sales, profit margins, dividends and the like. Filtering stocks that earn a 15% profit growth year-over-year would be criteria for your fundamental investing system. Or buying stocks that pay a 4% dividend yield and earn 10% on capital may be your criteria for this type of fundamental system. TECHNICAL systems use no company data; they rely on TRADING data for the stock as buyers and sellers trade it on the stock exchanges.
This data is chiefly price and volume, so there are fewer moving parts to contend with – often a plus. This data is then plotted on a CHART with other man-made indicators. Your fifth grade math teacher no doubt first introduced you to charts for visually representing a relationship between two variables; say MONTHS of the year and the number of INCHES it rains per month. If your job is a technical analyst, you are looking at many charts to determine what to buy and sell, and when to buy and sell.
At its extreme, using this type of ‘system’, an investor wouldn’t even need to know the company name or any fundamental data. In essence, a technical analysts’ premise is that all the known news, analyst’s opinions, the millions of buying and selling decisions in the market are already reflected in the stock price, and thus they toss out all of the fundamental data. They are looking for trends and repeating patterns in the stock price that can be used to profit – or avoid loss. Let’s face it – at the end of the day, the value of any stock is exactly what someone else will pay for it - no more, no less.
For diversification efforts, however, one should use a bit of each of the two systems using fundamental and technical-based information. You wouldn’t want to own all technology sector stocks or all utility stocks unless you’re a real risk-taker. So a blend of the two systems is what many smart investors and traders pull from their arsenal. Let’s run though an example of this.
A system you design using fundamental and technical systems may state: “I will buy stable, growth-oriented, dividend-paying stocks with 3% or more dividend yield across 8 broad sectors (fundamental criteria), and use a technical analysis system of a 5 and 30 day moving average crossover as my buy and sell price points”.
What the heck does that mean? I’ve preached in this space many times the value of limiting your losses in bad markets so your money can “live to fight another day”, so to speak. If you want to play in the big league of investing, you must learn some methods for staying in the game. A basic technical graph of a stock would plot the price and volume along the axis of the graph as shown below for Research in Motion shares.
Once you open the chart, resize that window so you can continue reading along while viewing the chart if it appears small. Click this link for chart: Research In Motion
The market has not been kind to RIMM this year; the shares are down about 70% (ouch).
The price scale here runs along the verticle “y” axis on the right side, and the trading volume and time line shown along the ‘x’ axis, or bottom horizontal portion of the graph. Price and volume are the two key ingredients to a chart (think flour and milk for cake-making). Next, indicators are added to the chart to give the price data some meaning. I am using 5 and 30 days referenced above as trading days of data that are averaged or smoothed so as to create a visible relationship. In this example, five days of prices are averaged for the blue line, and 30 days of prices are averaged for the red line.
When the shorter term 5 day blue line crosses below the 30 day red line, it’s a warning sign that the stock is close to selling. Conversely, when the blue line is below the red line and then crosses over the red line, then it’s a candidate to buy. You may be frowning and saying, “How can this possibly work?” Well, it works because stock prices move up and down in cycles. A stock that gains 25% will have to gain 5% and 10% first, so this is a “trend following technical system”: strong stocks often keep on getting stronger and move up in price. A stock like RIMM that can't get its 'mojo' going and start any significant trend should be avoided. Note the short one-month period around September that you had any chance to make money in RIMM.
Click the name for the next chart: iShares Silver
If you own a stock with a big gain, this trend following technical system can tell you when to sell it (our next chart) – you don't need your gut feelings, or TV talking heads soothing your fears, nor glowing analysts reports on what may happen next quarter, no discussion with your co-workers around the water cooler – you SELL because the ‘system” says so. I hope you are understanding this?
Next we will pull up a chart of the iShares Silver Trust, the exchange-traded fund that tracks the silver bullion price. SLV is the trading symbol. Here’s an example of how to use this technical system to prevent giving up some big gains. SLV had an 85% runup in price in about 3 months (January-April) earlier this year. We were aboard for some nice gains here for our clients.
Note the BUY point near $28 in early February when the blue 5 day crossed the red 30 day line. You then had 2-1/2 months of a nice uptrend before the peak price of $48 was unsustainable and the SELL signal came about $40 when the blue/red cross-over occured; a 43% gain. Looking closer at the chart, you will note that I chart the prices November 2010 thru May 13, 2011 so you could view the data better. Longer term using this system, you would have bought at $18 in August 2010, and sold in February 2011 for a 60% gain, then bought two weeks later at $28 and sold at $40 for a 43% gain. Total gain +120%. If you bought at $18 and didn’t sell until today at $31, your gain would be +75%, a noticeable spread.
So what can go wrong? A trend following system when there is no trend could result in some losses as you may get “whip-sawed”, that is, buying and selling based on the chart signals with no gains realized. Or you don't test your system adequately in real-time to see if it works. (The 5/30 day perhaps is not optimal for IBM but works great with Silver). You gotta test. But…the basic life-saver lesson students is that you will normally own a stock when it is moving up in price, you will NOT give back big gains or profits when the price starts to fall, and you will NOT own many stocks when they are not showing an uptrend. Since 75% of the price movement in a stock is a result of the overall market’s direction, this system has a built in defense mechanism: you are out of most stocks in bad bear markets and you are in stocks during rabid bull markets. I didn’t say that I’ve found the Holy Grail, but the proof is here that using a system will most often prove financially beneficial vs. having no system, or a system with so many variables and inputs that you can’t follow it reliably or don’t have faith in it.
The KEY to any system is to have the discipline to follow it. That’s where most investors stray.
Remember, any investment that you can plot on a chart can benefit from a technical analysis system described; gold, corn, crude oil, bond ETF’s, even mutual funds. This year’s sharp up and down prices for stocks are not giving us many opportunities for holding stocks longer term. With last week’s strong market action of +7% preceeded by the prior week's -5%, most stock indices are flat year-to-date. But there are always sectors and stocks that buck the trend and can make you some coin if you are diligent. It does take some homework however.
I hope you found this rather complex topic helpful. Do post any comments or email me with your questions.
Happy Holidays and Merry Christmas if I don't post again before then.