Good business rules are important. However, even those who make up great rules tend not to follow them. Most people lack the consistency to stick to those rules even when things go wrong.
Make the decision. Will you be consistent in following your rules or not? Most people who invest or trade never make the decision. It is almost impossible to be a consistent winner in the stock market without the consistent application of good decision rules. Think about how the market reacts to the news. The government releases a new jobs report showing that more people are unemployed. Immediately, the market crashes. A foreign country’s debt rating is downgraded and panic engulfs the market. Stocks plunge in many sectors. What’s going on here? Just as an EKG can tell a cardiologist a few things about a person’s heart function, we can consider the market to be hardwired into the nervous system of millions of investors.
There is a stimulus and a response. Depending on the nature of the stimulus, the response is reasonably predictable. The market reflects emotional states of the population. To make a profit in the stock market, it is necessary to avoid thinking like the rest of the population. When the stock pushes the market lower in a panic selling fit, the negative attitude about owning stocks is at its peak. However, that is precisely the time when people should be most positive about owning stocks. The individual investor tends to feel the same as the general population. Following a set of rules consistently is therefore difficult. It often forces a person to act against their emotions.
Suppose, for example, that you have just bought a stock with a fantastic story. Blixis Company (BLIX) has just discovered a permanent cure for the common cold and has the patent rights to the serum. The stock is at $10 a share, and you notice that it has been closely following an uptrend line. You buy it for $10 when it is right on the trend line. You think this stock is likely to go up to at least $100 and probably split several times before it stops going up. After a week, the stock is at $15 and is still moving along the trend line. One day you are looking at the chart of this stock and notice that it has fallen below the trend line. It is selling for $15 but the trend line is at 15.46. What do you do for a living? Do you tell yourself this is just a temporary profit-taking episode and decide to keep holding? Two days later, the trend line is at $17 and the stock is still at $15. Do you tell yourself that “stocks fluctuate and you have to give them room to fluctuate” or do you sell? At $15, the stock is 11.76% below the trend line.
Most investors in this situation would continue to bet. However, if you still hold, then you have to face the fact that you probably don’t have a strategy at all. He has bought a “story share” and is psychologically locked into it because he believes his story. A strategy consisting of a set of decision rules allows a person to draw a line in the sand and say “this is where I disconnect.” The probability that a person will succeed in the scenario described above, without adhering to the dictates of a good set of decision rules, is not great. What happens if the FDA insists on obtaining additional data before approving the drug? Then the stock would plummet. It could take a year or more to acquire enough data to satisfy the FDA. What if, while you wait, another company comes up with a cure that is based on a slightly different process that will allow the company to make your drug more cheaply than Blixis Company can make your drug? If that happened, BLIX would probably crash and you would still own the shares.
A consistent strategic investor who follows the rules times his purchase so that he can buy when the risk of a further decline is minimal. It never marries an action. Finally, always have an exit strategy, because unexpected bad things happen. In fact, these are the general principles that traders/investors of the trading disciplines follow. Beyond these general concepts, an investor/trader must have well-defined specific rules for buying and selling. For every buyer, there is a seller. One is more likely to make money on one trade and the other is more likely to lose money on the same trade. Without strictly adhering to a solid strategy, take a guess at which one is most likely to be.
Copyright 2018, by Stock Disciplines, LLC. aka StockDisciplines.com