When a know-it-all generates media attention and a large following, the advice given will immediately be followed by those so influenced. If the advice is to buy, it will stimulate buying demand and create a short-term advance. If the advice is to sell, it will stimulate selling supply and create a short-term depressing effect. By their own behavior, the followers of the know-it-alls are creating the short-term illusion that the advice was correct. True profitability, however, requires a successful outcome when the investment is concluded. Price fluctuations between buy and sell points is of no practical concern. When the king know-it-all's turn comes to be pushed off the mountain (through losses), the followers experience the worst of two worlds. They bought after the advance and sold after the fall—the usual result of irrational behavior.
In our actual portfolio modeling, we generally buy into declining prices and sell into advancing prices. This can be somewhat frightening, especially when strategies are first implemented, because positioning is initiated against prevailing sentiment and there is often some short-term price movement against our original price. This "strain" comes with the turf. The entry and exit points, however, are logically predetermined. Interim price movements are of no concern. As Drach's published portfolio modeling has clearly demonstrated over many years and throughout a variety of market conditions (with 95 percent of individual stock positions concluding profitably), perhaps the heavily publicized know-it-alls don't really know much beyond good salesmanship.
Rumors
A constant irrational threat to logical strategy is the rumor. Rumors often sound something like, "My brother-in-law's sister's cousin knows the secretary to the assistant vice-president and, here's the real inside story on the next earnings report."
A trait of rumors is that they are often passed along in low whispers. As a general rule; the more sensational the rumor is, the softer its tone. A characteristic of any rumors is that it was once a firsthand secret, but to be a rumor, at least two persons must be involved. So at best a rumor is secondhand by definition.
The primary difficulty with rumors is that they might not be true. The cause of untruthfulness may be an honest mistake or an outright lie. It is not beyond some of the less honorable members of the financial community to start false rumors in the hope of selling their stock at inflated prices to the gullible. This behavior tends to be most prevalent during periods of euphoria, when the more naive are attracted to the market in the hope of finding a stock that will skyrocket in price. Such fraudulent bait and trap schemes are usually confined to low-priced, low-volume stocks where the manipulator can more easily control trading. However, large well- known corporations are not immune when stock market activity is dominated by speculation centering on takeover and leveraged buyout activity. The managements of the corporations involved might have no idea that a false rumor is having an effect on the stock's price.
The mechanics of these schemes need not be discussed because one can largely avoid such abuse by staying with higher-quality issues. It is somewhat analogous to getting mugged: The chances of its happening are greater in a bad neighborhood than in a good one.
A common problem with rumors is that, even when the rumors prove to be true, it might not affect market price. Many an investor who has purchased a stock because of rumored optimistic earnings reports, which subsequently materialize and receive publicity, sees the price of the stock remain unchanged. The reason for this is generally that not enough investors cared whether the earnings were good or not, and the supply/demand balance is not altered. For its price to change in a predictable pattern, a stock must have a following (or have a good chance of developing such). Investors have to be interested enough to put their money in the stock. People determine stock price and volume. If people are not interested, the stock will not be affected by either rumor or actual news. This is another reason to stay with stocks, such as those on our Master List, that have an established investor interest.
The most disappointing result of optimistic rumors is when they come true and make news, only to have the stock immediately decline. This phenomenon is so common that many investors adopt the inane philosophy of buying on bad news and selling on good news. These theories are extrapolations of basic irrational behavior and as such are worthless. The reason for a price decline on good news can be found in the elementary understanding of supply/demand. As a rumor of pending good news proliferates, it creates buying demand, which will tend to advance price. When the rumored event is made official, it creates a selling supply among the group that bought because of the rumor. Their stimulus (the announced good news) for buying or holding the stock is gone. If this selling outweighs the buying in response to the news, the price will go down even though the news was positive.
Rumor utilization goes beyond ethics and price effect. When investors become reliant on rumor, they place their financial fate in the hands of another person. In doing so, investors put themselves into the equivalent of a financial iron lung, relying on the charity of others for sustenance and always in danger that someone will purposely or accidentally pull the plug.
One of our basic investment goals is independence, and that can be gained only by correctly understanding the strategies being used.
In the development of our investment method, the effect of rumor on price change cannot be ignored, but neither can it be satisfactorily measured. Our only reasonable reaction to rumors is to ensure that they work as much in our favor as possible in our development of a market timing technique.
Rumors are almost invariably associated with future events. By using the stocks on our list to aid in determining market timing, we are concentrating on issues with high predictability. Rumors surrounding these stocks are more likely to be unfounded and serve primarily to over- or underprice the specific issues affected, thereby adding to price volatility and our potential profit.
Do not assume that rumors are an insignificant factor in that they affect only a limited number of stocks at any given time. There are conditions during which rumors are the motivating force behind the entire stock market. A recent example is the rumor hysteria associated with leveraged buyouts prior to the crash of 1987. Dramatic price gains were recorded as a result of nothing more than rumors that hundreds of corporations were going to be taken over at ridiculously high prices, encouraging mass speculation. The market, of course, went splat.
It is a natural reaction to initially believe what you read, hear, or see as the truth. We are born rather helpless and to assist in deferring death it is beneficial to avoid harsh disagreement with superiors. Moms, dads, teachers, older siblings, church, state, and others in authority, combine to give us written and oral direction. Irrespective of how inane we recognize any particular directive, the usual outcome is to follow it out of the fear to do otherwise might require a disproportionate hardship—like no food.
As we (hopefully) are allowed to mature, the bombardment of verbal/scribed directives is unrelenting. In age, there can be an attempt to fight back, instilling one's own values. However, it is an elemental fact that from birth to death we are subjected to the attempts of others to have their wills dominate our actions. That's life. That's sales.
With that little biological/psychological background, it should come as no surprise that when entering a new environment it is easy to accept what you are told without question. The market is a business. The business depends upon sales. Those directing sales efforts involve some very competent, ethical people. There are also idiots, liars, and thieves.
The rewards for successful sales efforts can be dramatic. It is only natural, therefore, that the securities industry attracts some very persuasive salespersons, so persuasive that their "advice" is often comfortably accepted without question and/or hesitation. These sales experts can be brokers, analysts, advisors, or financial publications. We are combining them here into one category: know-it-alls.
Surprisingly, there does not seem to be any direct correlation between the ability of a particular know-it-all and the size of its following. This is most easily observed in financial publications whose past advice has been recorded in print and therefore makes it difficult for them to deny that they gave erroneous advice. To determine the validity of such services, all you need to do is check past results throughout a variety of market conditions. Although past results cannot be considered indicative of future performance, it certainly is the only valid measurement of performance to date.
Whether through lethargy, ignorance, or the emotional appeal of a sales effort, the fact is that a significant number of people are willing to follow the advice of know-it-alls without any reasonable investigation of true merit.
The Importance of Know-It-Alls
From our perspective, the importance of widely followed know-it-alls is an understanding of their effect on our strategy. Some know-it-alls are direct competitors; they will either be buying or selling at the same time as we will be buying or selling. Fortunately, they are in the minority. Most advisory services recommend buying when prices are high and selling when prices are low. The net effect is that they provide us with buyers at high prices and with sellers at low prices. Through their losses, they furnish us with profits.
The reason for their losing behavior can be that know-it-alls do not understand the market. The more probable cause, however, is the difficulties inherent in the sales aspect of the financial industry. The public, the know-it-all's primary customer, is most interested in the market after prices have advanced. To facilitate sales, the know-it-all is benefited by being positive after price change. This positive image during high markets does two things: (1) It correlates with the mood of potential customers. (2) It can give the impression that the know-it-all recommended purchase when prices were lower, when, in fact, the know-it-all did not recommend purchase until after the advance. Conversely, if a service is stressing purchase in low market periods (necessary for profit optimization), it can give the bad impression that the service had recommended purchase before the decline, which would hinder sales.
When an individual know-it-all (or a group) generates a great deal of media attention, the publicized advice can have the effect of aggravating pricing. Among heavily advertised analysts (including those with a large subscription base and those on the payroll of major securities firms), there is a constant game analogous to children playing King of the Hill. Someone gets on top of the heap (always temporarily) until knocked off by others who combine their efforts in hope of achieving their temporary fame.
The entire, repetitive process—ascent to splat to ascent to splat—really amounts to nothing other than a media-induced game. Upon careful analysis, the statistical result is generally that those participating provide results no better than those achieved by taking the whole lot and throwing them in a bag and seeing the normal bell-shaped distribution with standard deviations. In other words, the perceived best turns out to be the worst on the next count and the worst then turns out to look (temporarily) like the best. Round and round they go, where they land everybody with any common sense knows: no better or worst than the others.
What is important in this nonsensical circle game is recognition that the temporary king attracts a disproportionate amount of money to follow the advice (after the fact) that led to the hilltop. It is yet another lure to the exception, clouding the rule.
The short-term effects on price are real in that the highly publicized advice will attract buying/selling to push prices in the direction of the advice.
Whenever one acquires something new—dentures, automobile, spouse, or stock—the closest examination and greatest excitement take place immediately after the acquisition. In the purchase of a security, it is only natural for most investors to be very impressed by the first price change. For the naive, this is when hope is highest and interest most keen. If the price immediately advances, it can be cause for self-congratulation. If the price declines, it can be cause for self-doubt. For many, the early price fluctuations will be most memorable, even if the final outcome is destined to be opposite the initial price change.
The belief in random walk can function as a convenient excuse for incompetent money managers and financial academics. If so, so be it. It has been our personal experience, having spent our adult lives in the stock market that changes in market prices are sufficiently predictable to provide a nice livelihood, and the overwhelming majority of price changes havealways been predictable.
Random walk is fallacious. Drach's published models—without any possibility of hindsight or omission, over many years, and throughout a wide variety of market conditions—have maintained an accuracy rate of over 95 percent as to individual stock positions concluding profitably. The market is far from random. We welcome hard core random walk advocates—as long as we are able to "randomly" take their money in 19 out ofevery 20 stock positions.
Indexing
Based on the random walk theory, indexing is the portfolio strategy that selects stocks similar (or in the exact proportion) to those issues that comprise a popular average. For example, the portfolio may be composed of the same stocks that comprise the Dow Jones Industrials.
Presto! Do we have a method that can never do worse than the "market"? No. It is a method that can never do better than or equal to the "market." Even if exactly parallel to the components, the return will be minus managerial, clerical, and transaction fees. If the capital contribution varies, such as in a mutual fund where purchases and sales can fluctuate, there is the disadvantage of being forced to sell low (when fear dominates) and forced to buy at high prices (when greed dominates).
Why anyone is compensated anything over the minimum wage for monitoring such strategies is questionable. The strategy in itself is an admission that both management and participants have given up hope of outperforming the overall market.
We like Indexing funds because they help provide us with buyers when we want to sell at high prices, and they sell us stock at depressed prices.
Dollar Cost Averaging
Widely utilized, this method contains a type of logic that less imaginative investors can be easily led to believe. It is therefore a popular financial sales tool. It is a hybrid of random walk in that it implies direct attempts at market timing are impossible, but acknowledges that advantage can betaken of price fluctuations.
The dollar costing process is simple. At regularly spaced time intervals an identical dollar amount is applied to a particular investment (usually aspecific stock or mutual fund). In doing so, when the price is lower more of the investment will be purchased than when the price is higher. Over time, theoretically, the average price paid will be relatively low.
This technique overlooks some very important realities. First, it is a basic principal of the stock market that what goes up must come down (at least partially), but what goes down does not necessarily go back up. This is a truism painfully learned by investors who have used dollar cost averaging in corporations or funds that collapsed. Second, the technique does not incorporate any value for the time the money is invested. If the issue in a dollar cost averaging program stays flat (no appreciable price change) or is relatively high for extended periods and low for brief periods, the benefit of the averaging effect is minimized. As a result, the monies invested may very well underperform the inadequate return of conventional savings. Third, there is no way of knowing the opportune time to sell, since there is no objective method of judging when the investment is over- or underpriced. The important market benefit of liquidity, as well as the recognition of optimal periods of cash conversion, is lost.
Most important, dollar cost averaging methods can be demonstrated to be truly successful when prices are relatively low and more of the investment was purchased. Applying basic logic, why bother to buy during the periods of higher pricing? If the buying is confined to periods of decline, the results would generally be superior.
Because the method is an easy one to sell, dollar cost averaging will always be present in the market. It is, however, an amateurish application of random walk. From our viewpoint, it is a welcomed technique because it furnishes us with buyers at high prices.
Discipline and psychological certainty in themselves do not guaranteesuccess.
However, successful market techniques are basically disciplined, repetitive mechanical processes that regularly produce profit. They are regimented procedures through which the individual places funds with sufficient confidence of success to avoid panic. The differential between the pecuniary benefit or detriment of any method is the difference between the knowledgeable and the inane interpretation of the true nature of the market. The problems experienced in ineffective methodologies can invariably be traced to misconceptions about which factors actually do (and do not) significantly influence stock prices in predictable patterns.
The Search for Systems
Words such as techniques, methodologies, and strategies can be recognized by any horse player as pinstriped terms for systems. The origin and search for systems probably goes back to the first cave dwellers willing to bet their bones on contrary perceptions as to which brontosaurus was the most fleet-footed. Today, in every structured situation in which money is exchanged, the search for systems continues.
In our case, the search is for systems to beat the market! Formulated in an atmosphere of (often tedious) disciplined research, many claim to have discovered rather easy-to-use systems whereby the founder achieves a surefire way to riches. By definition there is an apparent dichotomy in the attempt to combine an admirable trait, discipline, with a less commendable characteristic, lethargy.
However, you must remember the market does not favor moralists. Nothing in the rules states that those who put forth the greatest effort are entitled to reap the greatest rewards. In such an environment, it is onlyreasonable to take the easiest approach, which is to review the results of the labors of those who have spent years (often lifetimes) in developing systems, utilize those aspects that have been shown to be beneficial, and discard those that are not worthy of consideration. This is a lethargic scheme, but lethargy has never been noted as a cause of ulcers or heart failure, and, applied to investment, it allows you more time to spend enjoying the profit you have attained.
Unfortunately, the search for beneficial systems is not easy. Most stock market techniques do not come with any reliable consumer warning label. Even more unfortunate for the naive is the fact that some of the most publicized and widely accepted methods, although they may superficially appear logical, do not provide satisfactory results.
Hundreds of disciplined strategies are published and have some following. However, classifying the strategies to isolate their deficiencies and strengths is not as complex as the raw numbers suggest. Almost all disciplined strategies can be placed in one of 13 basic categories. The larger number of published methods generally only have a small difference (usually insignificant) relative to the core strategies we will discuss.
Random Walk
One of the most widely taught and followed disciplined investment strategies stipulates that, especially in the short term, stock prices can not be forecast with any reasonable degree of accuracy; that is, price changes are random. Fundamental changes that affect stock prices are recognized, but are considered as unpredictable, with the market prices affected immediately adjusting for such changes and consequently of no benefit in accurate forecasting.
The theory that stock pricing is haphazard used to be generally confined to academic settings. Those who while away their hours in ivory towers found they could (can) statistically show that price forecasting was (is) impossible. Their problem was (is) that they did (do) not know what they were (are) missing in their calculations. The theory has been around for a long time, continues, and has grown in use in market strategies.
To those not familiar with random walk theories, the initial reaction is often, "Hey! No analysts are going to get up and say the market is random.
They would look like absolute idiots!" Think about it. Most will state something along the line, "No one can accurately predict the market, but I have something special so give me your money because. . . ."
But wait a minute. The noticeable lack of people having made this amount of money is proof enough of the delusion of most super-percentage-returning pyramiding techniques.
While the table demonstrates that the compounding results of a consistently profitable investment strategy can generate dramatic results over time, consistency of profit is the key. We have found that a reasonable expectation for logical, consistent strategies is an annual percentage gain of between 15 percent and 20 percent, depending on the particular technique and objective. The lower end involves the more conservative applications, with the higher levels generally associated with more rapid trading methods. For the average investor, a 15- to 20-percent annualized return is a reasonable objective.
At first, deluged by advertising that huge gains are consistently possible, the novice might quickly conclude that a strategy providing 20 percentseems too low. However, when considering the risk minimization factor and the compounding benefits, the results of a compounded 20-percent gain are quite dramatic when compared to what has been documented by any unleveraged investment type over an extended period.
Contrary Opinion
These systems incorporate a wide variety of market theories, all based on the concept, "Since the majority lose in the market, success lies in doing what the minority does." Many contrary opinion techniques have demonstrated successful records over time, but most experience difficulty in achieving profit consistency. Those following contrary opinion must, by definition, be in the minority. There are times when the majority does win-significantly. The problems with the contrary opinion advocates is determining precisely what they are contrary to and why.
We have already mentioned the inane reasoning behind any strategy that blindly buys on bad news and sells on good news. We have, however, isolated benefits to be derived from buying into declining markets and selling into advancing markets. This buying relatively low and selling relatively high is fine (that's what makes profits). But both profit consistency and profit optimization must incorporate valid measurements for determining what is really relatively low or high.
If a stock is proceeding downward, it may have very good extrinsic reasons for doing so; it could even be going out of business. Conversely, if a stock is advancing, it may well warrant the price increase. The contrary opinion advocate, going against the majority, may therefore be very wrong. The majority, in fact, are always right (at least temporarily) when they are influencing price moves by their own creation of demand/supply imbalances.
This reaffirms our reasoning for staying with seasoned issues whose fundamental characteristics are well known, those on the Master List. With reasonably predictable fundamentals, the determination of over-/underpricing has a logical base. We can then combine both intrinsic and extrinsic factors to allow us to decide when it is truly time to be contrary.
The decision as to when to act in accordance with contrary opinion is a function of both price and volume. By monitoring historical P/E ratios, you can see when the prices of the stocks you follow are reasonable or ridiculous. In your attempt to catch market tops and bottoms, you need to also attempt to determine when the weight of trading will shift between supply and demand. Simply being aware that prices have advanced or declined does not in itself provide any clear indication as to the duration of the price move before the reversal. Identification of the reversal pointis made easier by measuring changes in volume.
If volume increases dramatically and market prices also change dramatically, in either direction, the indication is that (for whatever reason) aninordinate amount of financial force is being applied that cannot continue indefinitely. Most investors attracted to such situations are most influenced by immediate price changes—emotional speculation. They will reverse their opinion if the price direction does not continue. By concentrating their power to disrupt the demand/supply balance in a brief period, they may have quickly exerted their maximum effect on price. With their power having been utilized, a reversal (often quick and dramatic) in price can follow on much lower volume. The more volatile the price change associated with heavy volume, the more those creating the volume are prone to irrational behavior.
Being aware of the importance of volume, we have now taken another step in developing our general framework for timing buy and sell decisions. To buy, we look for downward shifts in P/E, plus relatively steep price declines in a brief period, plus relatively heavy volume. To sell, we look for upward shifts in P/E, plus relatively steep price advances in a brief time period, plus relatively heavy volume.
Pyramiding refers to a variety of touted investment strategies, most of which heavily utilize leverage (margin), that can give the impression that tremendous profits can be made through very high annualized returns and consequential compounding.
It is common to see advertising that tremendous profits have been obtained by means of a particular investment type or trading technique. In the world of money managers, a constant source is the results of investing "championships" where the winner made huge gains or publications which specialize in monitoring several advisory services where the current winner has demonstrated a very large percentage return. It does not take much imagination for those lured into the belief that these returns are truly possible on a consistent basis to develop delusions of financial grandeur by simply placing their money as the advertising dictates.
The basic problem with these strategies is simply that they do not work consistently. The results are invariably temporary: What provided a dramatic gain during one time period (generating publicity) will likely generate a dramatic loss the next period (with no publicity because now there is nothing to sell).
The elemental fact is that there is a real relationship between risk and reward. The attainment of extremely large gains incurs inordinately large risk. If one makes 100 percent in an investment and then applies all proceeds hoping to duplicate the process, eventually a large (perhaps total) loss will occur. This wipes out the investor no matter how much money was gained previously.
With their irrational basis, pyramiding patterns are easy to recognize and avoid. Their mention, however, allows us to further formulate our timing and trading strategies.
In functioning in the market as a professional, your participation must be continuous. That is, no risk can be afforded that will put you totally out of business or destroy the capital base so much that it becomes difficult or impossible to expand on the original amount invested.
In general, the greater the percentage gain attempted in any particular investment or with any investment strategy over a specified time period, the greater the risk becomes. A balance, therefore, must be sought in which the annualized percentage gain is maximized without incurring inordinate risk: a combination of profit optimization and capital preservation.
To put capital growth in an understandable context, which shows the multiplying effect of $1 generating various rates of return over different time periods. This is a basic table that does not continuously compound on a daily basis. The percentage return generated is added at the end of each year rather than at shorter time periods. This table is, however, all that is needed to demonstrate the effect of compounding and provide a reasonable basis of what should be expected from market involvement on a consistent basis.
For example, let's say we place $10,000 where it makes 15 percent a year, and we leave it alone for five years. That is, at the end of each year we leave the money alone so that it continues to generate a return at the same percentage rate. To find the value at the end of the five-year period, we find year 5 in the left-hand column and then move horizontally to the column of numbers under "15%." There we locate the number 2.011. The value of the $10,000 has increased to $20,110 ($10,000 x 2.011) = $20,110.
To ensure that you understand the use of the table, let's take one more example: $10,000 allowed to compound at 20 percent for 18 years. By looking at the table, the multiple is found to be 26.623. The final amount would therefore be $266,230 ($10,000 x 26.623).
Many sensationalized techniques portray gains around 50 percent a year. Let's see how this works out when pyramiding. As can be calculated by using the table, the compounding effect of a $10,000 investment at such a rate for a period of 30 years would be $1,917,500,000 (10,000 x 191,750), just shy of $2 billion. Wow! So easy to get super rich!
