The story about Abraham Wald’s work as a member of the Statistical Research Group during World War II can shed some light into money management (widely disseminated as Abraham Wald’s Memo). Wald was tasked with damage assessments to aircraft that returned from service over Germany, and determine which areas of the aircraft structure should be better protected. He found that the fuselage and fuel systems of returned planes were more likely to be damaged than the engines. He made a totally unconventional assessment: Do not focus on the areas that sustained the most damage on these planes that returned, but focus on the essential sections that came back relatively undamaged, such as the engines. By virtue of the fact the planes returned, the heavily damaged areas did not contribute to the loss of the aircraft, but losing the engine would, and therefore would not return. Hence focus on more armor around the engines. For an airplane in battle, protecting the essential parts; and it will fly again. Investing is not unlike an airplane in battle, protect the assets from destruction, such as large losses (drawdown), and the investor will live to invest again. Most of modern finance is focused on the non-essential parts. You can do an Internet search on Abraham Wald and find many examples with much more detail. I first read about it years ago in a statistics book and have seen it repeated often.
Most blog authors on StockCharts.com are writing about the current markets and do an exceptional job. I do not write about the current markets as I wanted to share my experiences after 40+ years as a technical analyst. Not only experiences with trading and investing, but model building and money management. I also share the details of all the Master’s degrees I have – those expensive learning experiences that hopefully I learned something from. Since I rarely go back into the archives of other’s blogs that I read, I wondered if that is common or not. Hence, after talking with Chip, a summary of my past articles might encourage new readers to take a look as most of the material is timeless. That’s timeless, not worthless! This is the fifth of the summary series and starts in April, 2016 and ends in July, 2016. I’ll try to do future summaries whenever I have a dozen or so articles to include. You can click on the article name for a link directly to the article.
This is the third article dealing with cognitive biases that totally screw up your decision making. The first article, Know Thyself, covered anchoring, confirmation bias, herding, hindsight bias, overconfidence, and recency. The second article, Know Thyself II, covered availability, calendar effects, cognitive dissonance, disposition effect, and loss aversion/risk aversion. Most of my education on behavioral investing came from books by James Montier, Hersh Shefrin, and Thomas Gilovich. Two great websites for this stuff are from Tim Richards and Martin Sewell.
When I started getting interested in technical analysis, there was no internet, no Amazon, only bookstores. The investing section was usually quite small and the technical analysis sub-section only had a few books. Fast forward today and things have changed considerably. Fewer bookstores and most available online. Amazon seems to dominate. Technical analysis books are everywhere; you have your giant bible-like tomes from Kirkpatrick, Pring, and Murphy. There are hundreds dedicated to a single discipline and there are still many in the “get rich quick” category.
I am not sure why there are so many vague and totally subjective analysis techniques that have become part of technical analysis. Probably because the main stream Wall Street and their marketing department, academic finance, does not follow technical analysis like they do the accepted rubbish from the ivory towers. Early in this WHY series I tried to be convincing that technical analysis’ basic premise is the analysis of price; price that is determined in the auction marketplace.
Overbought / Oversold – These terms have got to be the most over-used terms when talking about the markets. Overbought refers to the time in which the prices have risen to a level that seems as if they cannot go any higher. Oversold is the opposite, prices have dropped to a point it seems as they cannot go any lower. While this sounds simple enough, the term is usually based upon someone’s personal observation of price levels and not on sound analysis.
There are many reasons I use technical analysis instead of some of the other analysis methods, but more importantly I have faith in it. Read on!
The other popular discipline is called fundamental analysis. This method of investing is essentially based upon fundamental ratios or as they are often called on Wall Street, multiples. Many followers of fundamental analysis also break it down further into a growth or value approach. The more aggressive growth approach is the hunt for stocks that are currently not registering any multiples (no earnings, no sales, etc.) and they are sought because of the analyst’s assessment that they have potential for growth. The value approach deals with good multiples (good earnings, good dividends, etc.). The value approach is what Warren Buffet uses. Gosh, if he uses it, it must be good. Keep reading!
Why are there entire businesses setup to make forecasts? The answer is quite simple; forecasting exists because there is a giant market for it. Investors/traders thirst for forecasts. Here is the real question; why do investors want to hear/read forecasts?
“Those who have knowledge don’t predict. Those who predict don’t have knowledge.” Lao Tzu
I often hear technical analysts performing their craft on economic data, derivative data such as the AD line, and a host of other data sets that do not trade. Why would you do that? The most basic premise of technical analysis is PRICE, the price that is determined in the auction market by traders and investors making decisions. Price is an instantaneous view of supply and demand.
Webster defines Odds and Ends as different kinds of things that are usually small and unimportant. I would prefer to define them as sort of important. I’ll use this format for issues that I cannot justify an entire article on. So expect Odds and Ends II at some point.
If you buy a mutual fund you are not buying a money manager, you are buying an objective manager. Let me explain. Many, if not most will choose a mutual fund based upon its performance over a period of time or the victim of exceptional marketing. Too often I think the period of performance is void of bear markets such as the last 7 years. This does not give a valid representation of the fund’s performance over the long run. The fund rating companies show 3-year, 5-year, 10-year, and since inception or at least close to those. Many funds have only been in existence much less than the 10-year time period. Okay, I drifted off subject.