At the heart of my trading success over the years are two basic concepts that I'm constantly trying to refine.
The first is to react to market action rather than to try to predict it, and the second is to use an incremental approach of many partial buys and sells in various time frames when investing in or trading a stock. I will discuss the actual application of these two principles in great depth elsewhere but it is extremely important to understand the philosophy first. Why should you avoid making predictions and why should you use a partial buy and sell approach?
The Futility of Prediction
The longer I've been in the market the less confidence I have in predictions. Wall Street and the business media love predictions because they make for good stories. When Bob Blowhard predicts that the market is going to crash, it receives much coverage but no one ever does any analysis of how often these sensationalistic predictions work out. Even when they are correct the timing is never very precise.
Embracing the idea that you can't predict the future is extremely powerful.
A few folks claim to have seen the Covid crisis coming but no one accurately predicted the twists and turns in the market this year. People like to pretend that had some special insight but the truth is that the folks that made the most money this year are those that had the best reactions to the changing circumstances and not those that tried to make grandiose predictions.
Embracing the idea that you can't predict the future is extremely powerful. It allows you to react much quicker and to take advantage of what surprises might occur. When you are dogmatic about predicting the future you have to overcome your built-in bias and you will have to fight your inclination to not admit you are wrong.
I have no idea what the stock market is going to do next year and I don't even want to try to predict. What I do know - without a doubt - is that there will be ups and downs and if we react effectively we will produce exception gains. It doesn't matter if the indices finish the year higher or lower. It is reacting to the shifts that will produce big gains.
Why not just admit that we don't know what the future may hold rather than pretend that we have some special insight?
Incremental Buying and Selling
If you embrace the idea that prediction is futile then it makes sense to use the same thinking when entering and exiting trades. We never know if we are buying or selling at the exact perfect time so why pretend that we are? The alternative is to handle your trades reactively as they develop. Rather than make a single buy and sell, enter a trade with the idea that a good stock will perform over time but we have no idea what the journey will look like. The stock may drop first, languish, or just take off, and we need to be in a position to react to each situation.
When I enter a trade I am optimistic about it working but I'm also prepared for the likelihood that it won't immediately turn into the greatest stock ever. I want to take advantage of the volatility that is likely to happen. When a stock drops I want to view that as an opportunity unless there is something fundamental that has changed.
The partial buy and partial sell approach is the embodiment of the thinking that you can't make precise predictions. You never know how a stock will act so rather than pretend that you can, it is better to react to conditions as they change by making partial buys and sells.
There is a host of considerations to keep in mind when using an incremental trading approach but the first step is to recognize the philosophical basis for it. When you realize that stocks seldom will do what you hope they will do then you are in a much better position to design effective trades.
Many people view predictions as the heart and soul of the investing process. That thinking is reinforced by traditional Wall Street and many pundits that want you to be dependent on them. Success in the market is primarily a function of effective reaction, a clear trading strategy, and recognition that we don't know what the future may hold.