A Dash of Insight

New Year's Resolution: Understand that Action Requires Confidence

Most individual investors make a major mistake: Looking for a "hot hand."  They spend a lot of time and money chasing last year's (or last month's!) performance.  Quite frankly, this is also the attitude of many top Fund of Fund managers who earn big salaries.  Find the hot hand!

Why?  The biggest reason is that it is easy to do.  Anyone can look at performance versus benchmarks and act decisively on the basis of a little information.  Even long-term track records can be unpersuasive to those who decide that the manager has "lost it."  The recent track record seems like unassailable, objective evidence.  In fact, it is one of the fastest ways to lose money.

Why are Warren Buffett's investors willing to sit through a weak stretch of performance?  Because they understand his approach and methods.  He makes sense.  Combine this with the long-term record, and it is quite reassuring.

Evaluating Trading Systems:  A Source of Confidence?

Evaluating a trading system can, in theory, provide as much confidence as reading one of Warren Buffett's annual reports.  Since very few people have this skill, it is even more valuable.  Most trading systems offer eye-popping results that can never be attained in practice, usually because the developer created a perfect fit to all of the past data.  Most system evaluators become accustomed to seeing these claims and expecting much less.

The average investor may not have all of the quantitative and methodological skills to evaluate a trading system, but it is right to be wary of anything that seems too good to be true.  Every method has periods of losses and imperfect signals.

Confidence in one's approach is the key to taking action even when times are challenging.  Those who lack a system flit from idea to idea, always trying to catch the last wave.

TCA-ETF Update

As we have been doing each Thursday for several months, we are attaching the weekly update of our TCA-ETF model.  This was designed as a means for readers to look over our shoulder as we designed and implemented a new method.  We also thought that other ETF investors might find our rankings to be interesting.

Somewhat to our surprise, we got a number of inquiries about investing in such a program.  Since this is a daily trading system for a limited partnership we are limited to 99 accredited investors.  But it got us wondering.  Could we adapt the program so that the average investor could enjoy the same technological advantage.  After some thought about trading frequency and number of positions, we did a five-year test of the model.  We were delighted by the results.  It turns out that weekly trading of ETF's is almost as good as daily portfolio adjustments.

This program is immediately available to any interested investor for whom it is suitable.  The model is just starting a new cycle, and the Gong has sounded.  We believe it to be a good time to begin or add to equity positions.  One advantage of the TCA method is that it goes completely to cash in extended bad times.  The investor does not need to worry about trying to do market timing.

We will provide a report on the methods and testing to anyone who is interested in taking a look.

This week's ratings are a little misleading, since we use the Wednesday closing data.  Today was an excellent day, and we now have a total of six positions out of 44 ETF's in the universe.  Below is the table as of yesterday's close.

New Year's Resolution #3: Do Not Let an Investment turn into a Trade

There is an old rule -- and a good one -- for traders:  Do not let a trade turn into an investment.

For individual investors we submit the alternative:  Do not let an investment turn into a trade!

Individual investors tend to look at big declines and bail out of their positions at market bottoms.  They are trying to time the market.  This is a mistake related to time frames, a topic we have carefully covered.

The individual investor is likely to look at a newspaper and think that it provides fresh information, even though the market may have already factored this in.  Individuals also get worried when markets decline, something that is a natural and recurring event, and choose to sell at the worst possible moment.

Acting effectively at these times requires an extensive knowledge of overall factors, market valuation, and overall potential.  Few investors are willing to do the homework required to make these decisions.

It also requires experience, and an understanding of behavioral psychology.  These are times when one's investment advisor earns his fee.

The Big Mistake

Investors get afraid, and do so at the wrong times.  Here are two interesting perspectives.

A trader on CNBC was commenting on his morning trades today.  That trader was buying the big opening decline (as were we) and wondered who was selling?  "What were they thinking?", he mused.

My RealMoney colleague Scott Rothbert, the finance professor and fund manager at Lakeview Asset Management, has a wonderful educational series for investors at TheStreet.com.  It is both free and valuable.  An individual investor should set aside time to read the entire series.  Scott wrote at length this morning.  Here was the "money line" for the individual investor:

If you are an investor then invest but don't switch gears into trading mode just because of current market emotion. Sticking to your model is another one of my basic tenets.

This is wise counsel from someone who has been there and knows.

Is it Time to Add to Positions?

Individual investors who have too much of their portfolio in cash, bonds, or real estate, should be asking when to add to equity investments.  This is the one time to think about what traders are doing.

Adam Warner is trading, not buying, and doing it against an options position.  He is not trying to time an entry point, and his viewpoint deserves respect.

Pradeep Bonde discusses the days after 9/11 and the poor advice from talking heads on CNBC.  We remember this and agree with Adam.  The market will find a valuation level that reflects expectations.  The time after 9/11 was not one where investment managers would do "patriotic buying."  Investment managers were trying to figure out what stocks were worth.  They were (sadly, but obviously) worth less than they were before the attacks.  The question now is how much of the current concern is "in the market."  We agree with Pradeep that one cannot know by watching interviews on CNBC.

Brett Steenbarger looks at other panic situations and analyzes subsequent returns.  Dr. Brett is the "go-to guy" on trading psychology.  His conclusion is especially meaningful for the individual investor:

The moral of the story is that, in the short run, panicky markets can decline further. Investors with longer time horizons, however, have generally done well by putting money to work when panic fills the air.

Our Take

Our conversations with investors show that many are too heavy in cash and real estate.  The market has offered an opportunity to change the asset allocation at favorable prices.  We are finding many attractive stocks.

The Fed is on the case.  The President and Congress seem to be working toward an agreement.  Since many pundits do not understand how government works, they underestimate the potential.  For many investors it is time to do some buying.

Another wise commentator on CNBC, Vince Farrell, suggested "dollar cost averaging." What he means is that there is an opportunity to take a partial position.  If stocks move lower, buy more.  If stocks move higher, at least the investor can participate.

This is good advice for the nervous investor, something that we have successfully suggested in the past in our discussions of "when to pull the trigger."  It is much better than selling at the bottom.

New Year's Resolution #2: Define the Agenda

A consistent theme at "A Dash" has been the application of knowledge that is well known in social science, but not understood by most market participants.  This is something you will not read anywhere else.

In political debate, one of these themes is definition of the agenda.  Those who define the terms of the debate will win.

The challenge for investors is to understand and to apply this concept.  Most market pundits define the question in a way where they have an obvious answer.

But what if they are asking the wrong question?

A Typical Example

The current market comment from John Hussman (excerpts on Seeking Alpha) argues that central banks are doing "liquidity absorbing" transactions so the "liquidity injections" are misleading to investors.  We cannot find a good quotation to summarize this, so read the article to check yourself.

Regular readers of "A Dash" will readily see the problem.  So will anyone who is following blogs by economists.  The Hussman evaluation does not accurately describe the policy goals of central banks.

Central banks are doing two quite different things.  They have reduced interest rates and added liquidity.  They have also adopted innovative methods to get liquidity where it is needed.  This includes the ECB injections, the Fed's TAF plan, and the swap agreements between the Fed and European Central Banks.

Conclusion

We attempt to avoid ascribing motives to market pundits, but we are mystified by the Hussman commentary.  He is an informed observer, albeit one who has been on the wrong side of the market in recent years.  It would be more useful if he were to comment on how the various liquidity moves were working in terms of the stated goals of the central banks.

Instead he is setting up a straw man and knocking it down.  This is a classic debater's tactic.  Astute investors should beware of pundits who ask the wrong questions.  Discovering the real issues, and the right questions to ask, is one of the most important challenges to an investor seeking to understand the global economy.

New Year's Resolution:  Think for yourself in determining the right questions. Read critically.  The first step to good investing is defining the issues and the agenda.