Final Version, 1/28/07
One of my resolutions for 2007 was to change my trading habits to have a longer term focus. I've thought this for some time, but since long term trading (AKA investing) is more difficult than short term trading, I haven't been very diligent about the change. Every now and then I get motivated to try for a longer term orientation, but every time facts convince me to return to short term trading.
The difference in short term trading and long term investing is just a matter of when you take profits, when you pay taxes, and what kind of taxes you pay. No one I know has ever advocated buying and holding forever! But the bottom line must always be income after taxes, which is what usually convinces me to pursue the short term course, despite being whacked by the tax man.
But short term trading is labor intensive, and I might not always have the time or energy to continue, so I remain interested in the longer term investing process. Here I review some of what I've learned about trading and investing.
About Analysis
The key to good investing is to perform two kinds of analysis of potential and actual purchases: fundamental and technical. Fundamental analysis concerns business artifacts such as sales, earnings, growth, and price. Fundamental analysis is about what to buy and sell. Technical analysis is about market sentiment: exuberance and fear, at the extremes. Technical analysis is about when to buy and sell. Short term traders rely mostly on technical analysis, while long term investors tend to rely on fundamental analysis. The best strategy is to understand both.
You don't have to do your own fundamental analysis, although you do need to understand it. There are many many sources of pre-digested fundamental analysis. Any popular financial publication contains loads of recommendations, as do many Web sites. I'm partial to reading Seeking Alpha on the Web, but there are more sources than you can count. Remember, for every seller, there is a buyer. Someone is optimistic about every stock! The main value of fundamental analysis is to build a comfort level, understanding the optimists' point of view.
Technical analysis is another matter altogether. You must know what you're doing.
I use two completely different kinds of technical analysis. One, known as "point and figure (or P&F)", is very crude, very old, and almost forgotten in the modern world. The other, Japanese candlestick analysis, is also ancient, but also state-of-the-art. I use P&F charts to determine the general direction of trading and Japanese candlesticks for exact timing.
There is no way that I can fully explain technical analysis. Lots and lots of books have been written on the subject. I suggest reading Stockcharts.com's excellent tutorial.
About Strategy
Surprisingly, there are only two broad strategies for investing or trading. One is to invest in companies and securities that are doing well. Fundamental investors call this growth investing, while technical traders call it momentum trading. The primary difference between the investor and the trader is the amount of patience they have and the tools they use.
The other investing strategy is to invest in companies and securities that have done poorly, but which you expect to do better. Investors call this value investing, traders call it reversion to the mean or swing trading.
While there are countless variations concerning the details of how to go about it, all investment or trading strategies are either growth/momentum or value/reversion strategies. Each has it's advocates and both have been very successful at times.
But which is better?
Some recent research indicates that the best approach is to do some of each. Now that implies a lot of work!
Trend Following
Many traders and investors use a trend following strategy. These can be fundamental trends such as earnings growth or dividend growth, or these can be technical trends such as moving averages. Even value investors and swing traders can use trends, although what they will look for are situations where trends are starting to change.
With all the varieties in trend following, which works best? There is no definite answer, or at least not that I've been able to find. Every now and then, someone publishes a supposed answer to the question, but these answers have always been refuted by reality. For all practical purpose, it seems to me that the different trend following approach all have similar prospects.
Against the Trend
Not everyone follows the trend. Some investors and traders, generally known as contrarians, routinely bet against the trend. Critics sometimes call this “catching a falling knife.” This is a particularly difficult way to invest, but many legendary investors, such as Warren Buffet, have done very well with this approach. Nevertheless, only a small minority (by definition!) can buck the trend. Not only does this approach require more work than trend following, it also requires the psychological ability to see long stretchs of time with weak or even negative results. This is truly an approach for the exceptional investor, so I will say little about it.
Indexing
It's popular in the consumer investment press to praise the advantages of indexing, i.e. using index funds. I have nothing against index funds – in fact, I use them a lot, but the consumer press uses some weak arguments which can lead the unsuspecting to some dangerous conclusions.
Perhaps the best thing I've read about indexing, and how to use it, is this article. One of the obvious advantages of indexing is that it offers broad exposure to a market. Broad exposure means that there is very little risk from an adverse turn of events in a single company. However, there is still risk that comes from the overall market (called market risk or systemic risk) and indexing offers no protection there. It is just as easy to lose money with indexing as with investing in individual stocks. There's no free lunch!
Given all the options, and all the conflicting opinion about what works best, what is an investor to do? I can only offer one piece of advice: keep working on it and keep learning. Practice improves skill. You may not have the time or inclination to spend several hours a day working at it, but pick some tolerable time cycle - whether it's daily, weekly, monthly, or quarterly. Learning is the important part, and learning requires being organized and systematic, remembering what you've learned. If you never the make the same mistake twice, you will make fewer mistakes. Successful investing is not out of reach, but it's not free and it's not easy.