Wednesday, November 11, 2009

An “all you can eat” buffet or a gourmet dinner?

Although the minimalist “less is more” has become something of a mantra in a downsized economy, it hasn’t resonated with enough active investors and traders. When confronted with a stock screener or technical analysis software, some people (especially those new to the table) act as if they’re at an “all you can eat” buffet. If one screening criterion or one technical indicator is good, two must be better, three better yet, and all the boxes filled in or as many squiggles as the chart will accommodate the very best. These people don’t start with a hypothesis; they just throw every tool they can think of at the job, where the job is defined as winning or getting rich quick.

This is madness. And, yes, we’ve all been there. With any luck we’ve managed to escape from the asylum. First of all, tools by themselves produce nothing. The investor or trader has to use tools to produce results. So the novice starts to introduce rules, usually complex rules since he has so many tools to use—buy when the P/E ratio is under a, when the dividend yield is above b, when the year over year revenue growth is above c, and when the relative strength is greater than d. Or buy when the a-period moving average crosses above the b-period moving average, when the ADX is greater than c, and when the d-period stochastic is less than e. He mixes and matches until he gets something that looks halfway promising on a (flawed) backtest. If he really curve fits, he can get stunning backtest results. He’s off and running, on his way to great wealth. If only Goldman Sachs had had a trading model like his, they could have posted even better quarterly numbers.

Contrast this smorgasbord model with one proposed by a sophisticated investor or trader who wants to sit down to a gourmet dinner. She will choose her restaurant carefully, knowing that she won’t get a gourmet meal at Wendy’s or Outback Steakhouse. She will proceed with some general observations about the restaurant’s food, taking into consideration restaurant reviews of particular dishes and the seasonality of produce. What will trump everything are her personal preferences. Brussels sprouts may be the restaurant’s claim to fame, but she hates them. Before I get really hungry, let me quickly transition to the trading environment. I know the analogy is forced, but I don’t have far to go. The savvy investor or trader first has to define her market, the restaurant. Then she has to make some macro calls (for instance, in a weak dollar environment the U.S. stock market tends to be strong, overnight gaps are filled x% of the time) or adopt a hypothesis (it is impossible to predict market outcomes) and structure a trading plan in accordance with those observations or hypotheses, all the while taking into consideration her personal preferences. She is trying to choose a meal where one dish complements the other; if successful, she leaves the table thoroughly satisfied, not sated and in need of an Alka-Seltzer.

I know, I should never have gone down this path. But here and there a metaphor becomes a little shop of horrors. And there’s no way to claw back. Tomorrow will be better.

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