Building your Trading Algorithm around Constants

Written by Michael Bigger. Follow me on Twitter.

 

 

A constant is something that is changeless or a quantity that does not vary. The concept of constant in trading is really important. Let me explain why. 

 

In a fast-changing world, consistency is only possible if you manage to some things that do not change. If you don’t manage to the constants, you will most likely be all over the place and compound return negatively. You need a beacon, and your set of investment/trading constants is that beacon. I discuss Jeff Bezos' opinion on the topic in this blog post. 

 

Bezos says: “It is important to focus on what’s not going to change in the next five to ten years.” The same is true with investment management strategy.

 

What’s not going to change in your investing or trading business in the next five to ten years? You might want to build your strategy around that.

 

Here is a list of some of the constants I use:

 

• Stocks fluctuate: they are volatile.

• If you see a roach in the cupboard, you will find many more: Cockroach Theory.

• Stocks are manipulated.

• Investors and traders overreact.

• In aggregate, diversified portfolios track the market return minus some.

• In aggregate, if a stock move after an analyst makes a recommendation, the move should   be faded.

• In a Levy flight news cluster, most sharp moves are erroneous.

• Intrinsic value has a much lower volatility than its corresponding stock price.

• Traders, when trading, behave like animals.

• Efficient market hypothesis: the market is information efficient. EMH does not mean securities are priced right.

• Positive information about a security takes more time to be reflected in stock price than negative information.

• Shelby Davis's Law: “A purchaser of common stocks makes most of his money in a bear market; he does not know it yet.”

• Corollary to Shelby Davis's Law: A seller of common stocks creates most of his value in a bull market, but he does not know it yet.

• Customers are more truthful than management.

• When opinions are diverse, stock prices approach fair value.

• When opinions are similar, stock prices diverge from fair value.

• Investors are fickle when they lose money.

 

Anything else I should be thinking about? Let me know.

 

 

Update on Wednesday, August 4, 2010 at 3:08PM by Michael Bigger

 Here is another constant:

•  Much of the prevailing information about the stock market is misleading.

Comments

[Arthur]

Thanks for that, nicely put. I got another one. Hoi Polloi is NEVER right about investing.

I was thinking today why I screwed up on gold call, with all printing of money around the world, with everything in economy showing that gold should go higher and not look back and with absolutely no reason for gold to go down there has to be some event that will happen and must happen that will bring it down and hard because hoi polloi is NEVER right about investing. AND EVERYONE is buying gold, all over the news, all over the internet and sooo many new shops with "WE BUY
GOLD", but of course I will get a margin call before that happens...

[Michael Bigger]

Agreed! I sold my gold futures on Monday. I have no more position. In my opinion, I think natgas is probably a better bet right here. I am also short US Treasuries as an alternative to being long Gold.

[Joshua Chance]

How about these...

Risk:

Volatility is to risk as correlation is to causation.
Risk is not knowing what you're doing. -Buffett
The relationship between volatility & risk is proportional to leverage and inversely proportional to knowledge/experience.

Investors and traders under-react. (post-earnings drift, etc.)

[Joshua Chance]

a corollary...

Risk from leverage and its mitigation from knowledge scale non-monotonically. (that should cover any future Nobel prizewinning hedge fund managers)

[Michael Bigger]

Joshua,

I like that! I like operating leverage not margin leverage.

[Joshua Chance]

Customers are more truthful than management
+
Employees are more truthful than management
=
Be short management opinion, ceteris paribus.

http://www.greatplacetowork.com/what_we_believe/graphs.php

[Michael Bigger]

Joshua,

Exactly! The b/s you hear from management is quite amazing. Example: Blockbuster's press release history before going bankrupt.

[Joshua Chance]

Yeah and if you didn't happen to catch it from the source, there's always the analyst echo chamber.

[Michael Bigger]

Chuckle!