There are many professional investors using iVIEWMarkets and many who are not. Either way, most average investors have ego’s that get in the way of learning how to become better investors. In my 20 plus years, I had the privilege to come across some of the most successful investors. They all have similar traits and the one that has always stuck out was being extremely “inquisitive”. They were highly inquisitive and wanted to understand and break down the mechanics of a particular deal, structure or mechanics of a particular indicator. They were also humble with regards to wanting to learn what they didn’t know. Lastly, they all had a process they followed and never deviated from that process.
So today we wanted to discuss a few simple concepts on how to improve your investing. These are basic concepts that should be learned before even developing your process. As many know, we have already discussed our outline for a basic process and the can be found here doc located here.
Before we go any further
The information we are discussing can be mastered by everyone who is passionate about investing. So if you are new to trend following, technical analysis or applying a rules based investment process it only takes time and some work.
First and foremost, we are trend followers and pay attention to price action. Why? Because not in a million years can we or you possibly be an expert in hundreds of companies in all sectors. We nor you have the time or bandwidth to know more about a company’s fundamentals than the sell-side or the buy-side manager who cover only 5 to 10 names in one sector. Plus, we feel when it comes to portfolio management, the longer term out performance comes from the management of risk and not the management of returns. Price action can provide an edge to the average investor who is not a trained analyst.
Momentum Buys
In our next email we will focus on specific buy rules. But remember, a consecutive rapid improvement in trend score is the most ideal situation, coupled with an ATR Trailing Buy breakout. An Example of this would be Metlife below, it consolidated with a 4 trend strength and rapidly increase to an 8. Remember, there is no forecasting of future price moves, we say this over and over as new traders and investors think there is some magical indicator that has the ability to make higher probability trades to decipher future price moves.
Keys to our Trend following methodology:
1. High Quality Fundamentals: Only invest in liquid, fundamentally viable S&P 500 companies that have several top sell side firms covering the stock. More analyst coverage of a stock and liquidity, helps increase efficiency and transparency. Granted, less covered stocks could offer greater returns, but we want to reduce as much of the unknown as possible to mitigate risk.
2. Diversification: I know this is an easy one, however; many people don’t realize the position size and max sector allocation is vital for portfolio performance. Also, remember cash is an asset class, and reducing and increasing exposure based on the trend strength of the S&P 500 can help mitigate portfolio volatility.
Addressing the correct position size is tough without a systematic process or large staff. Managing the optimal portfolio of stocks is challenging for many as it’s difficult to stay on top of 30 plus positions with so many moving parts and is a daunting task. That is why the trend score in the portfolio section can be a good way to track the trend strength at a fast glance. Any positions with a score less than a 2 need serious consideration. Additionally, any position that rapidly falls from a trend score consecutively from greater than 6 to 0 needs immediate attention.
Position size: In our back-test optimization, we apply an equal weight for each individual stock as the market is random and don’t apply a greater weight to any one stock. Depending on the volatility target of your portfolio position weight is critical. We like 1.5% to 3% position size with a max sector weight of 25%. This is based on our objectives and not yours, you will need to figure out what fits your style.
3. One fundamental metric doesn’t fit all: If you are going to apply a multi-factor approach as we discussed yesterday (Momentum & Fundamentals) make sure you know the main fundamental key ratios that drive valuations for each sector. For example, in the Banking sector, tangle book (TBV) is a key valuation metric, but the multiple given to TBV by investors is a function of the banks ROE (Return on Equity). So applying the same metrics across all sectors obviously won’t work as technology investors are not concerned with TBV or even ROE for that matter.
4. Risk Management Drives long Term Performance: Keep it simple. Having a target exit is a waste of time and effort when trend following. It’s that simple, tying yourself down to a target price will cause you to incur massive losses by riding big draw-downs that may never recover. Also, basic stop losses will also just whipsaw you in and out of the market eating up your capital. We have back-tested every variable utilizing stop losses and our conclusion is they impact the long term performance. We are much more partial to using ATR, moving averages and relative momentum (or our trend score) for exiting positions.
Key take away on exiting positions, we want to ride the trend for as long as possible until two things occur:
1. The price becomes fully exhausted and a counter trend reversal occurs.
2. Price breaks significantly from its long term trend off of historic highs (key reversal).
There are a couple of good tools that are not proprietary that can help achieve the above rules. Also, remember, this strategy is not meant for short term swing trading. Its meant for investors whose holding period ranges from 60 to 250 trading days looking for 10% to 30% returns. Of course using this methodology for shorter term trading can work.
Example:
An example of a counter trend reversal coupled with price exhaustion would be NEM Newmont Mining. NEM that had a unbelievable run over the last 9 months. NEM triggered a long trade breakout back in February. If investors utilized a volatility stop or aka Trailing ATR Stop, investors would have ridden the stock from $19 to $42 until the volatility stop triggered a stop after a 9 month run. By the way, for the greatest confirmation, we like to see a ATR Trailing buy couple with a trend score equal or greater than a 7.
Let’s look at our default ATR Trailing Buy and Stop with a time period of 20 and multiplier of 3 (seen below). In our next email we are going to discuss longer term overbought and the pitfalls of using RSI to reduce long equity exposure.
