4 minute read
Part 4 excerpted from lesson 5.6 of the upcoming Trade Like a Pro ver.10 course.
“You don’t need to know what is going to happen next to make money.” – Mark Douglas
Do we buy, sell, or hold? That is the question at the heart of every conversation about the market. Professionals know that “anything can happen.” But, what if the market goes up, down, or sideways? Our confidence determines our action, but what creates our confidence? We may trust the historical growth of the markets, or future innovation. The former looks backward and the later forward. Yet, we must make a decision today. Some buy, hoping the growth of the past will continue. Others hesitate and by waiting miss the opportunity as the market pushes higher. Professionals use hypotheticals to understand what to do if the situation were different.
Sears, Roebuck
The first stock I ever bought for clients was Sears, Roebuck. A month later, clients opened their first statement to more than they expected. The stock rose in value as we hoped.
During training at PaineWebber in New York, LeRoy Gross taught us how to analyze a balance sheet. Based on a few fundamental ratios we determined that Sears was a reasonable buy at its current price. I was proud we made money on our first trade. We next bought Prime Computer and again made money. Everyone was happy. Everyone said, “Buy good companies and hold them.”
Have you ever bought a stock and it dropped in value the next day? The result was as immediate loss. I have experienced loss. The third stock we bought lost money, the very next day. All the numbers said it was a great value, so we held on and it continued losing money until we finally sold it. It was an even better value when we sold it. But I learned a lesson.
Sears, Roebuck was a great stock, some called it the Amazon of the last century. But those who bought and held, lost everything.
We sold Sears early with an outstanding profit of over thirty percent. Luckily I learned from my third trade and never again held a position for a large loss. Because, losses have a greater negative impact, then profits have a positive benefit.
The next week I introduced myself to Ralph and Cantrell, who I mentioned in an earlier post. The taught me the the other half of the investment process that I was not taught in New York. One of the first lessons was the importance of using hypotheticals.
What are Hypotheticals?
”A tentative assumption made in order to draw out and test its logical conclusion or empirical consequences.” – Merriam-Webster’s Collegiate Dictionary
The market at any moment can go in one of three directions: up, down, or sideways. Each with a unique probability relative to the current market context. When dealing with an uncertain outcome, a researcher will apply the scientific method. Eric Reiss says, “Begin with a clear hypothesis…then test those empirically.”
We are not predicting the future, we are trying to anticipate what is most likely to happen. We base our anticipation on what has happened in the past, and what is happening currently. We try to understand how well either side is doing. These facts make up the basis of our hypothesis.
”A supposition or conjecture put forth to account for known facts…which serves as a starting point for further investigation by which it may be proved or disproved….” – Oxford English Dictionary
Doctors use the same process in medical diagnosis. They formulate several working hypotheses, ask questions and gather information. Observing tests results and further questions, ruled out competing diagnoses, until one remains.
Professionals use hypotheticals as low-risk trade ideas. They prove themselves by what happens in real time. Combined with a rule-based process and probability, the Pros are now prepared to act.
Why are Hypotheticals Important?
Hypotheticals enable Professionals to prepare for several outcomes, removing cognitive bias. When a hypothetical triggers, it’s acted upon immediately, without hesitation. By considering several hypotheticals you know which are wrong. You can act on the one in play without having to repeat the entire analysis. By watching what happens instead of listening to others, Pros avoid false hypothesis.
Professionals use cognitive dissonance to hold two or more hypothesis as possible. Professional trading is not based on prediction or timing. It rests on the probability between several hypotheticals. Any one of which may trigger an action.
Applying Hypotheticals to the Investment Process?
In each stage of the Market Cycle (which we will discuss in Part 8) Professionals anticipate the next market stage. This assumption has not and may not occur, but is the highest probability outcome. It becomes the expected hypothetical. But “anything can happen” so the Professional identifies what else can occur. They visualize all the ways the trade can go wrong. These become the alternate lower probability hypotheticals.
Armed with two or more possible outcomes, the Professional watches. The market will confirm or reject each hypothetical. The Professional acts on the confirmation of the hypothetical. This process once understood takes little time to analyze and execute. Whether the professional trades sovereign assets monthly, endowment assets weekly, hedge fund assets daily, or is a scalper trading in seconds, they all follow the same process.
The ability to identify hypotheticals and wait for them to set up, is what separates a Professional from the others.
Next Week
The Role of Fundamentals in the Investment Process
Starts February 1st
Trade Like a Pro ver.11 course starts February 1st. Endorsed by CSI and Moody’s Analytics for all financial advisors.
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