The Educated Trader – Issue 3
If someone were to pick you up in a helicopter, put blinders over your eyes, then drop you into the middle of a jungle, it’s likely you’d have a tough time lasting for any length of time. Undoubtedly, it’s hard enough surviving in the jungle, let alone with blinders on. The stock market is a lot like the jungle—it’s a dangerous place for those who don’t know what they’re doing, or even those who think they know what they’re doing. It isn’t a far stretch to see how biases (a.k.a. “blinders”) can compound the challenges posed by the wilderness of the markets.
When it comes to investing, we all have the same biases. This is because our brains have all evolved the same way. The trick is to be able to recognize our biases in our decision-making processes and work on countering them with the right behaviors.
Bias #1: I Know Enough, Therefore I Know Better
We all like to think that we are not as influenced by biases as other people are, which is our first and biggest investing mistake. Even professionals in the financial industry have biases that lead them to make less-than-optimal decisions. In fact, the more we know about a subject, the more confident we are that our forecasts will be correct. The reality is that information quantity is no match for quality; it’s not about how much you know, but what you do with the information you have.
So let’s get one thing straight: you know less than you think you do when it comes to investing, and that’s not a bad thing. You will never know all there is to know about the markets, and you will never gather enough information to give you certainty that an investment will perform the way you want it to. What really matters is separating the facts from the stories. Check your sources when you research an investment, and make sure they’re credible and reliable. Also, don't take information at face value. Instead, think carefully about how it was presented to you.
Bias #2: I See What I Want to See
Another big problem of ours as humans is that we tend to seek out information that confirms our beliefs rather than challenges them. It makes us feel good to listen to people who share our views, which means that we are likely to dismiss negative information on an investment that we favor. What’s even more interesting is that we tend to view information that contradicts our beliefs as biased itself.
To counter this thought process, we need to constantly seek out information and people that disagree with us. This is not because we want them to try and change our minds, but because we have to be able to understand and deconstruct the logic of the argument. If we can’t see the argument’s flaws, we should seriously reconsider our viewpoint.
Bias #3: Numbers are My Anchor
Anchoring is a term used to describe the tendency for us to stick closely to numbers that are presented to us. The most common example of this is anchoring to share prices. When we see a share price of, say $10, we tend to immediately believe that it reflects the underlying value of the company. Because today’s markets are highly liquid, company values don’t tend to stray significantly from their share prices. However, it is nevertheless important to come to your own conclusions about the value of a company. If there is a significant deviation between your evaluation and the share price, you may have a trading opportunity on your hands.
Bias #4: Good Performance Follows Good Performance
You’ve likely heard the old adage, “past performance is not an indicator of future performance.” So why do so many investors—even analysts—make the mistake of assuming that a good company with solid earnings over the past several years will continue to perform well? This belief stems from a type of bias known a representativeness, which is a phenomenon where we use a company’s past and current performance to predict its future likelihood of success. However, this bias can lead you down the wrong path, because future performance relies heavily on events and circumstances that will likely be quite different than those that exist today.
The key here is to determine a company’s competitive advantage, which is the strongest predictor of future success. Most companies out there are or will eventually become quite average, and over time, their performance will revert to the average. So you need to answer the question, “what qualities does the company have today that substantially distinguish it from its competitors so that it will continue to perform well in the future?”
Bias #5: A Loss Isn't a Loss Until I Take It
The tendency to hold on to investments as they drop in price is all too common. So why do we cling to losers? There are several biases at play here. First, we tend to value the things we own more than the things that we don’t. Whether it’s a coffee mug or 1000 shares of our favorite company, we prefer to sell the things we own for more than many people are willing to pay for them.
The second and biggest reason we don’t sell investments as quickly as we should is because of our aversion to taking losses. In general, we dislike incurring losses about 2.5 times more than we like making gains. We therefore tend to keep our losers longer than we should, and cut our winners sooner than we should. We rationalize the decision to keep declining investments by telling ourselves that the price will bounce back. Unfortunately, they tend to underperform the winners we have already sold.
The trick to avoiding this mental trap is to set up an investment strategy that requires you to buy and sell at pre-determined prices. To augment this strategy, you can “taper in” and “taper out” of investments, depending on their price movements. For example, if you plan to buy 1000 shares of a stock, start by purchasing 500 shares, then as the price moves in the direction you want it to go, buy 25% more. Continue to do so until you’ve reached your maximum number of shares. This same strategy applies to selling stocks.
Easy to Learn, Hard to Do
Although it is easy to understand our biases, it is much more difficult to know when they are influencing our decisions. This is why planning your investment strategy is so important. Planning allows you to predict scenarios before they arise and work out how to properly handle them. Don’t underestimate your brain’s ability to trip you up. If it happens to professional money managers and analysts, it will happen to you.
Trading Tools 101: Anatomy of a Candlestick Chart
A candlestick chart is an incredibly handy tool in the technical analyst’s arsenal. This is because it conveys a substantial amount of useful information in graphical form, allowing you to quickly establish an understanding of a given stock’s price movement.
Candlesticks represent the movements in the price of a stock over a short period of time. If you’re looking at a candlestick chart for a day’s worth of trading, each candlestick represents one hour. If you are looking at a chart that covers the span of several weeks or months, then each candlestick represents a full day’s worth of trading.
Figure 1 illustrates the information a single candlestick conveys. A candlestick has a wick on its top end and a tail on its bottom end, each respectively indicating the highest and lowest values reached over a time period. For example, if the price of a stock on a given day traded between $10.50 and $10.85, the top of the wick would indicate $10.50 and the tip of the tail would represent $10.85.
The body of the candlestick conveys the opening and closing price for the day. The color of the body of the candlestick indicates whether the closing price was higher or lower than the opening price. A white or green body indicates a higher close, and a black or red one indicates a lower close.
Candlestick Chart Movement Indicators
Figure 2 illustrates how the length of a candlestick’s body, wick, and tail can indicate the general sentiment of traders for that day. Candlesticks can indicate bullish, bearish, or buying and selling pressure. Different types of candlestick indicators have different names: there’s the hammer, doji, spinning top — to name a few. Each have their own statistical probability of correctly indicating price movements, with some having as much as a 60% probability of being correct. In the world of the stock market, those are impressive odds.
When combined with trend line analysis, candlesticks can be powerful tools in indicating future price movement. Figure 3 provides an example of how a candlestick can indicate the imminent change in the direction of a trend line. The first section of the chart shows an upwards trend that is topped by a candlestick that indicates selling pressure. Selling pressure is denoted by a long wick, a short body, and a small tail. This means that some investors were looking to cash in on the previous price increase. Consequently, we see a price decline following the upward trend as traders continue to sell over the next four days. However, the decline is short-lived as the price makes its way up towards a hammer candlestick. In general, when a hammer follows a sharp decline, it indicates that bullish traders are strengthening. In this particular case, it further indicates that a minor sell-off has just occurred and general sentiment remains positive about the future price of the stock.
Strengths & Limitations
Candlestick charts provide a clear visual picture of intra-day and daily price movements of a stock. However, like trend line analysis, it must be applied in the context of other information. A single indicator is not enough to reliably determine chart patterns. It is therefore wise to seek out a confluence of indicators that provide a general consensus before making trading decisions.
What are ETFs?
Last month (click here for last month’s issue) we discussed some of the benefits of owning ETFs in your portfolio. We will continue this discussion by delving into the topics of tax efficiency, portfolio transparency and flexibility, and liquidity.
ETFs provide a higher level of tax efficiency than open-ended mutual funds and most hedge funds. This is by design: buying and selling ETF shares on a stock exchange do not change the quantity of shares of each asset held by an ETF. In other words, an ETF pool is a self-contained unit of assets that doesn’t get bigger or smaller. On the other hand, when buying and selling shares of many types of mutual and hedge funds, the fund manager must purchase and sell the number of shares required of each asset in the fund’s portfolio to fulfill your order. Over time, as many people in the fund trade their shares, capital gains and losses accrue, translating into higher tax realizations for the remaining shareholders.
Portfolio Transparency and Flexibility
Another advantage to being able to trade shares of a fund on the open stock exchange is being able to obtain immediate, real-time data for the price of each share and the fund’s composition of assets. Additionally, because ETFs are pools of assets that specialize by region, market, sector, commodity or theme, there’s no need to accumulate the transaction costs--such as commissions--associated with buying individual assets to build a portfolio of equal risk and return potential.
Some assets are more liquid than others. For example, houses are very illiquid assets because it takes time to find a suitable buyer. On the other hand, ETFs are incredibly liquid and can be quickly purchased and sold during trading hours. Furthermore, because they are highly traded, the price of the ETF is extremely close to its actual value. In fact, the liquidity of an ETF can be greater than its holdings simply because it has a higher trading volume. This is unlike less liquid types of funds, which a seller might have to sell at a lower price than their true value just to “get rid” of them.
Next Month—Fixed Income ETFs
Our discussion of ETFs will continue next month as we delve into the topic of fixed income ETFs and how they can be a useful alternative to buying individual bonds and other fixed income securities.
Monthly Market Roundup
What Happened in the Market This Month
The biggest topic in the markets this past month was, without a doubt, the fiscal cliff. Talks were certainly heated, ultimately leading the US government to postpone the looming tax and spending changes that were supposed to come into effect on January 1st until February.
2013 Market Expectations
In the immediate term, we expect the noise factor in the markets to be very high in the coming months. It is possible that we will see it make new highs and possibly test the all-time highs before the next set of heated debates over the fiscal cliff and debt ceiling. Nevertheless, it is a good possibility that 2013 earnings growth will be significantly challenged as the global headwinds blow, which leads us to believe that there is a high risk of a 20% correction. This watermark will keep the markets above their 2012 lows.
Our forecast for the TSX is that 2013 will be its fourth year in choppy waters. The good news is that we should be able to get a few 10-15% rallies along the way and therefore squeeze out some positive returns again. However, with 50% of the TSX close to full valuation and with limited fundamental upside to revenues and notable downside risks in many places, it is hard to forecast much beyond a range bound market for this year.
We do not expect new highs for US technology companies, as an increasing number of important tech stocks are making longer-term topping patterns, but we do see the sector bouncing back somewhat relative to the broader S&P 500.
We expect 2013 to bring us approximately a 20% return on gold this year, which is our high point target. This may not translate into a 20% return for gold equities, although it could be more at times. In the past few years, gold equities have traded poorly because the sector has been out of favor.
The recent postponement of any big decisions on the fiscal cliff will only make it tougher to negotiate in February. With some analysts predicting that the US will not be able to pay its bills as early as mid-February, we will also likely see a rise in the US debt ceiling. As long as governments do not tackle the structural problems, the only politically palatable solution is to let the Federal Reserve monetize debt as quietly as possible and inflate the problem away. This can keep the party going for a long while, but does not make us economically bullish.
80% of the world’s equity market capitalization in a stagnating economic funk. The best way to make money in the years to come will be to emphasize higher dividend paying stocks when it is time to play defense and then shift to a growth focus when markets correct and it is time to play offense. We are terming this the “dividend growth” strategy and expect it can deliver 2-4% alpha per year for those willing to ride out the waves. The challenge is that there will likely be another 20-40% decline in the coming years, but we have no idea when. For a fixed-income strategy, combine short-duration corporate bond ETFs and longer duration high-yield ETFs. This is likely to offer a killer combination for investors in the years ahead.
Crude oil prices will probably remain stable as the global perception of North American self-sufficiency grows in the coming years. That theme should keep the Canadian energy sector from showing signs of growth and oil sands-weighted companies stuck in the mud of rising costs and flat-lining revenues.