The Traders Journal

After You've Pored Over The Charts And They've Yielded All Their Truths, Try These Tools

 | 

Yes, I'm a chartist.

Yes, I can glean profitable insights using my technical tools.

No, charts are not the only tool in my analysis bag.

If that were the case, it would be akin to buying a Ferrari while living in a studio rental. That would be totally out of balance. See, life – just like investing – is all about equilibrium. It's about balancing risk and reward. Yes, everyone wants to maximize the reward position but unfortunately, the evil twin of risk always tags along. The key to profitable long term investing is to embrace a clear appreciation of how much risk you are comfortable with.

Consider the following:

  • We each have a different "comfort zone". Understand your risk tolerance so you can sleep well. If you aren't sleeping well, you've taken on too much risk.
  • Know your investing timeframe. Your goals must be tied to your stated investment horizon. If not, you'll be constantly jerked around by the markets to do the wrong thing at the wrong time.
  • Risk tolerance is dynamic. Special situations during your life will impact your willingness and/or ability to invest in certain asset classes. Life changes. Marriage, children, college, health issues — all these and more can shift your risk tolerance. Just expect it! It's okay.


Without the buzz-word bingo that is so prevalent in our investing arena, I'm going to share with you five tools to help you better gauge the risk in any investment you're considering. All too often, slick investment schemers and marketeers will amplify the rewards portion and gloss over the risks. Risk, however, is present in every investment. Accept it and deal with it. Just do not ignore it – never ever.

Three decades of trading have taught me the following three rules about risk and investing:

  1. Investing requires a "second brain". In our book, Tensile Trading, the chapter titled "The Investor Self" describes the surgery necessary to get one.
  2. Risk can't be vaporized but with certain tools, investors can minimize the risks and increase the probabilities of achieving positive outcomes. 
  3. Risk is best understood and explored before peeling the dollars from your wallet. It's very very personal. I suggest you formulate bullish and bearish scenarios to help you balance and tolerate the inevitable risks before you have to stare them in the eye.


Okay, now back to the five tools I promised you. I'm about to pedestrianize material I learned from Professor William Sharpe at the Stanford Business School. As a Nobel Laureate and the creator of the Capital Asset Pricing model, he'd probably be mortified to know that I'm giving you such simplistic definitions. For those of you who are academic investors, feel free to explore each of the items on the internet and drown in the details!

So, here's how I use the Fab Five:

Alpha

Bigger the better. Positive is good. Negative bad. Great to compare two funds you're considering. The one with the higher alpha (historically) has produced better performance for the amount of risk it undertook. 

Beta

An equity with a beta coefficient of one (1) moves in nearly perfect unison with the market. Growth stocks often have a beta of 1.5— meaning they're 50% more volatile than the market. If that's too tough on your stomach, go for lower beta stocks (less volatile). I use Beta when formulating my asset allocation. Some funds have low betas and don't care what the market is doing. Great for diversification.

R-Squared

Sounds complex, but it's simple. If you are considering a mutual fund with an R-Sq of 98, you'll likely do better buying an ETF index and save fees. A high R-Sq identifies those supposedly active managers who are actually closet indexers. On the other hand, a manager with an R-SQ of say 75 is not just tracking an index or benchmark. For example, T. Rowe Price Global Tech Fund (PRGTX) has an R-Sq of 72. It's not an index fund. It's earning those management fees. It's alpha is greater than 13. It's an out-performer. Beta is 1.18 — as expected — a bit more volatile than the market. These, my friends, are the attributes of an overachiever!

Sharpe Ratio

Named after Dr. William Sharpe's students. Yes, it uses standard deviations and excess return to determine reward per unit of risk. Don't worry about that. The bigger the number, the better. Lesson over. 

Standard Deviation

I use Bollinger Bands. They are based on standard deviations. StockCharts.com has three variations under indicators you can try, and detailed descriptions you can dig into via Chart School. My cut-to-the-chase bottom line is this. Bollinger Bands measure volatility. It's been my experience that lower volatility supports rising prices, while rising volatility suggests lower prices statistically. Got it? Straightforward!


In conclusion, remember you can't control the markets, but you can monitor and understand the risks you are willing to take. Best do this before a crisis hits!


Trade well; trade with discipline!

Gatis Roze, MBA, CMT

StockMarketMastery.com

Gatis Roze
About the author: , MBA, CMT, is a veteran full-time stock market investor who has traded his own account since 1989 unburdened by the distraction of clients. He holds an MBA from the Stanford Graduate School of Business, is a past president of the Technical Securities Analysts Association (TSAA), and is a Chartered Market Technician (CMT). After several successful entrepreneurial business ventures, Gatis retired in his early 40s to focus on investing in the financial markets. With consistent success as a stock market trader, he began teaching investments at the post-college level in 2000 and continues to do so today. Learn More
Subscribe to The Traders Journal to be notified whenever a new post is added to this blog!
comments powered by Disqus