style="font-size:15px;"> The Motley Fools’ David and Tom Gardner’s pudding story is cute, but it’s misleading in design. Their plan gets you in, but it doesn’t get you out or tell you how much of that pudding stock you should buy. Many low information types believe that easy to digest narrative. I can only scream inside my head: “Houston, we’ve got a freaking problem!”
A second market theory, technical analysis, operates in stark contrast to the funnymentals. This approach is based on the belief at any given point in time, market prices reflect all known factors affecting supply and demand. Instead of evaluating fundamental factors, technical analysis looks at the market prices themselves. But an understanding of technical analysis can quickly become confusing and controversial. There are essentially two forms of technical analysis. One is based on an ability to read charts or use indicators to predict market direction.
And predictive technical analysis rightly deserves poignant criticism:
“I often hear people swear they make money with technical analysis. Do they really? The answer, of course, is that they do. People make money using all sorts of strategies, including some involving tealeaves and sunspots. The real question is: Do they make more money than they would investing in a blind index fund that mimics the performance of the market as a whole? Most academic financial experts believe in some form of the random-walk theory and consider technical analysis almost indistinguishable from a pseudoscience whose predictions are either worthless or, at best, so barely discernibly better than chance as to be unexploitable because of transaction costs.”33
This is the view of technical analysis held by most who think they know of it – that it is a form of chart reading, astrology, moon cycle analysis, chart pattern wiggle feelings, Elliott waves to the first, second, third, fourth, and fifth degree, and – Barry Ritholtz’s favorite one to skewer – the Death Cross. Big bank equity research departments add to confusion by asking the wrong question: “The question of whether technical analysis works has been a topic of contention for over three decades. Can past prices forecast future performance?”34
It gets worse. Consider a recent Red Alert example from HSBC: “The Head & Shoulders Top with the neckline acting as resistance comes on top of a potentially bearish Elliot Wave irregular flat pattern and the fact that the index is now backing off from the old 2015 highs. A close below 17,992 would be very bearish. Pressure would ease above 18,449.”35
Good luck with that.
There is a second type of technical analysis that neither predicts or forecasts. This type is based on reacting to price action, as trend trader Martin Estlander notes: “We identify market trends, we do not predict them. Our models are kept reactive at all times.”36
Mebane Faber expands on reaction by noting three criteria are necessary for a model to be simple enough to follow, yet mechanical enough to remove emotion and subjective decision making:
1. Simple, purely mechanical logic
2. The same model and parameters for every asset class
3. Price-based only37
Instead of trying to predict market direction (an impossible chore), trend following reacts to movements whenever they occur. This enables a focus on the actual price risk, while avoiding becoming emotionally connected with direction, duration, and fundamental expectations.
This price analysis never allows entry at the exact bottom of a trend or an exit at the exact top. And you won’t necessarily trade every day or week. Instead, trend following waits patiently for the right conditions. There is no forcing an opportunity not there. And with this view there are not exact performance goals. Some want a strategy that dictates, “I must make $400 a day.” The trend following counter is, “Sure, but what if markets don’t move on a given day?” Trend following works because you don’t try to outthink it. You are a trend follower, not a trend predictor.38
Discretionary versus Systematic
There are investors and traders, and trading can be fundamentally or technically based. Further, technical trading can either be predictive or reactive. However, there is more distinction. Traders can be discretionary or mechanical.
Trader John W. Henry makes a clear distinction between the two strategies: “I believe that an investment strategy can only be as successful as the discipline of the manager to adhere to the requirements in the face of market adversity. Unlike discretionary traders, whose decisions may be subject to behavioral biases, I practice a disciplined investment process.”39
When Henry speaks of decisions that may be subject to behavioral biases, he is referring to those who make their buy and sell decisions on fundamentals, the current environment, or any number of other whatever factors. It’s a never-ending parade of data they can supposedly sift through and utilize. In other words, they use their discretion – hence, the use of discretionary to describe their approach.
Decisions made at the discretion of the trader can be changed or second-guessed nonstop. These discretionary gut-trading decisions will be colored by personal bias. I have yet to see a multi-decade track record produced by gut trading. It’s 100 percent fantasy. Many imagine the process is like a fighter pilot strapped into the cockpit armed with an instinctive feel, or even an innate gift. It’s not that.
Now, a trader’s initial choice to launch a trading system is discretionary. You must make discretionary decisions such as choosing a system, selecting your portfolio, and determining a risk percentage (some would argue even these aspects can be made systematically too). However, after you’ve decided on the system-orientation basics, you can systematize these discretionary decisions and make them mechanical.
Mechanical or systematic trading systems are based on objective rules. Traders put rules into computer programs to get in (buy) and out (sell) of a market. A mechanical trading system eliminates emotional vacillation. It forces discipline to stick with the process. If you rely on mechanical trading system rules, and break them with discretion, you are guaranteed to go broke.
Henry puts into perspective the downsides of discretionary thinking: “Unlike discretionary traders, whose decisions may be subject to behavioral biases, we practice a disciplined investment process. By quantifying the circumstances under which key investment decisions are made, our methodology offers investors a consistent approach to markets, un-swayed by judgmental bias.”40
Maybe it is rigid to say it’s against the rules to use a little discretion. You might think, “How boring to live like a CPA.” Where’s the fun if all you ever do is follow a mechanical model? Successfully making fortunes isn’t about excitement. It’s about winning. A researcher at Campbell & Company, one of the oldest and most successful trend following firms, is adamant: “One of our strengths is to follow our models and not use discretion. This rule is written in stone at Campbell.”41
Trend trader Ewan Kirk adds:
Systematic trading involves coming up with a statistical model of the markets. Assuming that model has worked in the past, and that you have developed and researched and tested your model correctly, then your hypothesis is that it’s likely to keep working in the future. So the actual execution
John Allen Paulos,
“Quantitative Strategy: Does Technical Analysis Work?”
Bob Bryan, “RED ALERT – Get Ready for a ‘Severe Fall’ in the Stock Market, HSBC says,”
Martin Estlander, “Presentation for the Association of Provident Fund of Thailand & Partners” (Association of Provident Fund of Thailand & Partners, Bangkok, February 26, 2015).
Mebane Faber, “A Quantitative Approach to Tactical Asset Allocation,”
Daniel P. Collins, “Kevin Bruce: Improving on a Passion,”
“Disclosure Document,” John W. Henry & Company, Inc. (August 22, 2003).
Ibid.
Carla Cavaletti, “Top Traders Ride 1996 Trends,”
