LT investments - taking risks and market randomness

[ottg]

While I'm doing these investigations for myself others may benefit from it. As the end goal is to select a portfolio of ASX shares better than any other offerings currently available. But this thread is about our own appetite for risk and if our own believe system sabotage us from good opportunities. Lets see and note that I'm doing this off the cuff from experience and from past learnings:

Two schools of thought:
a. In an efficient market the market price reflects the value of the business 100%
b. The true intrinsic value of a business is seldom reflected in the share market price

The school-(a) only looks at the share price, patterns, waves and don’t care about what the business does – these people are all traders: intraday (buy & sell the same day) and short term (buy & sell within a few days)
The school-(b ) looks at business fundamentals, financials, management and look for undervalued business with growth potential for the long term. They only look at trends to enter and exit their position (and they sleep sound at night) – these people are investors in my view.

They both operate in the same markets and may cause share price volatility due to market manipulation, greed, fear, emotions and perceptions. So whose wrong and whose right? Both are right as both make money and have losses – it is just a different vehicle to get to the same goal. If that is so then everyone should make money – but why don’t they? While this post is about long term investments we should go and learn from traders too.

The only rule you need to follow is that you have to make more than what you lose. But why is everyone not following this rule. Emotions and fear of the unknown i.e our approach to risk of losses.
Let see: Would You Take This Bet?
https://www.youtube.com/watch?v=vBX-KulgJ1o

Rule 1: We weigh losses twice as heavily as gain but….and we all have different limits.
Rule 2: Now if we have 50 wins and 50 losses but the wins are biased to give more back and we limit our losses – then we are guaranteed to always end up with more. Let the profits run and limit the losses. So why don’t we all make more, because we are afraid of the loss and stop/exit to early.

Can we learn something from good traders – they are masters in controlling their emotion. A quick read from Nick Ridge.

https://www.thechartist.com.au/images/stories/Trish/Successful%20Stock%20Trading%20by%20Nick%20Radge.pdf

Here is a different take on the above risk video and how it affects trading:

http://www.screencast.com/t/KMVrWO7V

Rule 3: The markets always trend either up (positive) or down (negative) and when its undecided (moving sideways) it’s never for years at a time. This is because of the nature of human active in the market (perceptions of bears & bulls)
To state the obvious: In the share market, if we have a quality share, it will grow in share price over time or it may lose market value as well. However statistically if the business grows in a healthy economy the share price will grow and therefore is biased more towards growth than shrinking. If that is so then the market is not random and Warren Buffet’s philosophy of buying and never sell is correct. We know we will lose some money sometime we just don’t know when.

Rule 4: It’s more a case that we need to get comfortable with the knowledge that we will have losses as we know we will have more wins.

Edited June 20, 2015 by ottg

[ottg]

If the markets are unpredictable then it must be random. But traders are using pattern and waves. So what is market randomness and what does it really look like and why is it important to understand?

Is the market really that random?

Here is my random market generator (Use key F9 to rerun). It starts with $1500. The strategy in this example is to limited both my up and down side to 10%. The randomness is slightly biased to win. Each row has 10 trades. After 10 trades the portfolio gets readjusted. Scrape 5% off the winnings after 10 trades for brokerage fees. Observe the patterns, sequence of consecutive losses and the ratio between win and lose. The number of winning runs and $ amount after each run.

260 Potential trades a.xlsx

Lessons learned: Most of the time you will make money if you do all 260 trades. You must make all trades. The sequential losses can occur for 7-10 consecutive cases. Often you don’t make anything. Often all my wins happen in the last 30 trades but often it’s not. If we play only one row (10 trades) and exit we will lose often. Always make sure you can stay in the game to play again. Used 33% of initial funds to ensure you can play again a 2nd and 3rd time – it is physiologically better and make us less afraid to lose because it provides a perception of abundance. It is a mechanistic process and consistent. The net winnings varies widely – no guarantees but the trend is more high than low. All these lessons are about randomness!!!

So back to long term investments: It is no way that I will buy and sell more than 20 shares per year as its just too time consuming – thus I’m not a trader.

Rule 5: Have a strategy. Decide upfront your position size, when you enter and when you exit. That is it!!

Rule 6: Be consistent and apply discipline

Rule 7: Select only quality shares

Rule 8: Review weekly and trim when needed but do not override your own rules. If no new shares to pick then stay in cash.

The only thing left now is how do we select quality shares – we already identified what quality shares should look like.