MLR - Why most nvestors cannot beat the major market averages over any given market cycle

Published : January 20 2013 at 13:10 ET

Many investors do not heed the following:

1) It's about price. Price is the only real factor. It determines whether you come out ahead of behind. Opinions and opinionated news contribute to emotional knee-jerk trading.


2) It's about quality. Buy leading stocks. Leading stocks have top fundamentals and technicals. Our strategies weigh the following fundamentals heavily: earnings, sales, industry group rank, institutional sponsorship, pretax margins, return-on-equity (ROE).

Meanwhile, top technicals are governed by the shape of the price/volume action relative to the general market. Buy liquid stocks that trade at least a daily dollar average volume of $12 million if you are in an environment that favors small caps, unless it's an IPO, in which case you might relax this rule. But remember that even in such a small cap favored environment, such stocks will carry higher volaility thus higher risk.

If you are in a large cap favored environment, stick to stocks that trade at least a daily dollar average volume of $24 million, unless the fundamentals and technicals are so overwhemlingly strong, in which case, you might slightly relax this rule.


3) Remember, volatility equals risk. Always know your downside when putting on a trade. Most investors focus on the profit potential. You should focus on downside first. The cardinal rule of investing is to control risk. Just as real estate is about location, location, location, investing is about risk, risk, risk.

Do not buy a stock that carries volatility above your maximum risk tolerance levels. In other words, if your maximum loss is -7%, do not buy if your exit point would bring a greater loss than -7%, even if the stock looks seductively profitable. High relative strength stocks (above 97) often carry high volatilities. Alternatively, you could buy a smaller position so you could increase your maximum stop loss.


4) Always know the weaknesses of your system. Markets change so your strategy may suffer a drawdown much as our Market Direction Model (MDM) suffered in 2012.

2012 is reminiscent of the second and third quarters of 1999 when the model had its largest drawdown in its history. During the second and third quarters of 1999, the NASDAQ Composite was the most volatile and directionless in its near 30-year history giving the model its worst drawdown at that point at -15.7%. Since then, 2012 has traced out an equally unusual situation, especially during the months of May through early August when the market moved just enough to trigger false buy and sell signals, giving the model its worst drawdown at -18.2%. Fortunately, such periods are aberrations and always have come to an end. Even though dark pools, high frequency tradingand quantitative easing have been alive and well since 2010, the Market Direction Model outperformed in 2010 and 2011 using NASDAQ Composite as benchmark (multiple by roughly 3x if using 3x ETF TECL):

2011 MDM +11.2% vs NASDAQ Composite -1.8%

2010 MDM +26.0% vs NASDAQ Composite 16.9%

Eventually, the market will catch a sustained trend - that is our continued belief. This has historically made a big difference in terms of overall performance over time, and this is the premise of the Market Direction Model.

Remember that most investors, when facing drawdowns, abandon their strategy without understanding whether it is due to a highly unusual market aberration, so either give up entirely or jump on board a new strategy that seems to hold great promise. This is what is known as chasing performance.

To understand how 2012 was such an unusual aberration in market history, it helps to know that the Trend Following Wizards which comprise fund managers who have been interviewed by Jack Schwager and Michael Covel in their 'market wizard' type books had one of their worst years in 2012 with two of the wizards (Dunn and JWH) down around -20%:


5) Investor, know thyself. Most of the battle is all about being aware of one's emotions when trading. If you don't understand your emotional strengths and weaknesses, your emotional weaknesses, if not understood and controlled, will inevitably cause steep losses. This is why highly intellectual people who sometimes lack deep understanding of their emotions often fail miserably when it comes to investing. They let their ego-driven intelligence outshadow their emotional intelligence. But when it comes to investing as with life, emotions always win over intellect in the end, so have rules that address any emotional weaknesses.

This information is provided by Virtue of Selfish Investing, LLC (VoSI) is issued solely for informational purposes and does not constitute an offer to sell or a solicitation of an offer to buy securities. Information contained herein is based on sources which we believe to be reliable but is not guaranteed by us as being accurate and does not purport to be a complete statement or summary of available data. VoSI reports are intended to alert VoSI members to technical developments in certain securities that may or may not be actionable, only, and are not intended as recommendations. Past performance is not a guarantee, nor is it necessarily indicative, of future results. Opinions expressed herein are statements of our judgment as of the publication date and are subject to change without notice. Entities including but not limited to VoSI, its members, officers, directors, employees, customers, agents, and affiliates may have a position, long or short, in the securities referred to herein, and/or other related securities, and may increase or decrease such position or take a contra position. Additional information is available upon written request. This publication is for clients of Virtue of Selfish Investing, LLC. Reproduction without written permission is strictly prohibited and will be prosecuted to the full extent of the law. ©2016 Virtue of Selfish Investing, LLC. All rights reserved.