My Trade Diary

Source: http://www.themoneyblogs.com/steve/my.blog/how-to-beat-the-market-consistently.html

There is a wonderful book about how to become wealthy and if you haven’t read it, I highly recommend that you do.  It is called “Think and Grow Rich” by Napoleon Hill.  It is not about trading.  As a matter of fact it really doesn’t tell you exactly what to do to become rich.  It is not even necessarily about how to gain financial wealth, but how to gain abundance of whatever it is that you do want in this life.  I think that for many of us financial wealth is one of our goals-it is one of the reasons (if not for some of us the only reason that we trade).  Despite this “goal” many people who take on the endeavor of trading consistently lose money in the markets.  As a matter of fact, that is the way that trading works-it is not that 60% of the people win and 40% lose, or 50% win and 50% lose...it is more like 2% of people win and 98% lose.  I don’t think that anyone has the real data on this, but the point is that there are a small number of winners being fed by a huge number of losers.  The question that you need to ask yourself is... what do this small percentage of consistently successful people do (it’s not what they know-it is what they do) that the other people do not?  I will do my best to share this information.

Well, the obvious part of this is that the successful traders are generally doing something that is very difficult to execute or else everyone would be doing it.  Additionally, their methodologies must be a bit displeasurable or else many others would stumble onto their winning ways fairly easily just because of “the fun of it.”  One of the greatest traders of all time, Ed Seykota, said, “everyone gets what they want out of the markets,” and I believe that statement is true.  This implies that most people do not trade to make money (or else many more people would be making money in the markets), but they trade for some other reason such as excitement, to get high, or to fail in order to gain sympathy from others.  In general, we are all human-and for the most part we are the same, we behave the same, we react the same, and we are followers by nature.  We are designed this way because it confers a survival advantage as a species.  So how does this apply to the stock market?

Because we all naturally do the same thing at the same time-we consistently overprice the “in favor” or best investments, and we consistently underprice the “out of favor” or worst investments.  This is true on an intraday basis, a daily basis, a weekly basis, a monthly basis-you get the idea.  On a grand scale, this was true of tulip bulbs in the 1600’s, bowling stocks in the 1960’s, precious metals in the 1970’s, real estate in the 1980’s, and internet stocks in the 1990’s.  This is also true of bearish sectors such as healthcare stocks in the early 1990’s.  On a weekly basis we see the same thing, if Wal-Mart misses earnings, the street may pummel the stock 10% in 2 days (or 1 day or in 1 minute as we all know).  In more cases than not, we overestimate the risk and overly trash the newly “out of favor” stock.  As the stock goes down, we as traders begin to second guess ourselves.  After all, if everyone else is selling, shouldn’t we be selling too?  “They” must know something that we don’t.  For some reason we begin to put more confidence in others than we do in ourselves-people do this all of the time when they cheat on tests, for instance.  If someone else has a different answer marked-studies show that people switch to their neighbors answer over their own.  It is human nature.  It is the way that we protect ourselves-to move with the herd.  The net effect in the stock market is that most reactions are over reactions.  The difficult part is to rise above this behavior, and the even more difficult part is execute your trades based on this information.

There is a whole group of traders who make money regularly using this very information.  They are the market makers.  When bad news comes out on an issue and everyone is selling at the open, believe it or not, they have to buy--that is their job; they must create a market when there is a disproportionate amount of buyers and sellers.  They buy on the terrible news (when everyone else is selling).  Guess what-when a company gets a new big contract or beat earnings and everyone is buying at the open and there are very few sellers-they are selling.  They must create a market for you to buy into.  So while everyone jumps on the bandwagon for good news, and vice a versa for bad news-these traders are doing the opposite.  And they make money...consistently.  I’ve talked to some market makers-their biggest edge is that they have to take these trades.  Could you imagine going short apple when it announces a new product or beats earnings--some of these guys have told me that it makes them sick when they take these trades.  But at the end of the year-they are winners while others are wondering what happened.

It should become clear that the answer to “How to Consistently Beat the Market?”-is to go against the herd.  In the world of investing we call this “contrarian” investing.  In essence, it is going against your gut reaction, the people that you respect, and your own instincts, and it is so much harder than I ever imagined.  But even more exciting is that it is even more fruitful than I ever imagined.  It is amazing, but no matter how you slice it-this method of investing consistently beats the market.  This is not subjective but objective with countless backtests.  You may think that if it is so easy, why isn’t everyone doing it?  Well, of the people who do realize this is a profitable way to trade or invest--it is incredibly difficult to trade or invest this way because of the reasons described above.  If you look at the TradingMarkets.com website-you will see that most of the content is essentially about using contrarian strategies- just take a look at the chart of any powerratings stock that is ranked 10--it usually looks like something that you wouldn’t touch with a ten-foot pole.  For the most part contrarian investing is so difficult to execute that this style of trading is rarely followed (hence, the small number of winners in the markets).  At the same time, I can not recommend enough that you invest  yourself in learning how to go against the herd-I promise that you will find that it is even more rewarding than just financially.

“Nobody beats the market, they say....Except for those of those of us who do”  David Dreman

Don’t play with the herd!

Steven Gabriel