These days we hear even more about ‘timing the market’. Ever stopped to ask yourself what this really means? Most people assume it means buying at the bottom and then selling at the top. But that confuses outcome with the process, because how are we supposed to know when the market is at the bottom? Well, would it surprise you if I were to tell you that actually there is no need to guess or think of where the market is headed?

The first reason why there is no such need is this: the diversified portfolio.

Why You Should Have A Diversified Portfolio

The theory behind the diversified portfolio is that it’s not possible to predict when things are at the bottom any more than you can predict how much the Fed will change interest rates. Investors in this school tend to run diversified portfolios which consist of assets spread out across large cap, small cap, international, bonds, commodities etc. and make periodic, regular investments regardless of the performance of the market. The idea is that the portfolio balances itself out regardless of the market movements. You can say that the international portfolio on the left hand side of this blog is such a portfolio. It is something which I have been adding the same amount of money to regularly every month for several years without looking at a single chart or reading a single report and which has earned an average between 8-12% a year. Over the past few months when equities have tanked, the bond and commodity counters have shot through the roof, eliminating the losses on the equities. If you are running a similar portfolio my advice would be to continue buying. If you put the same amount of money into your portfolio every month, you will automatically pick up more assets which are cheap and less which are expensive. Over time, this forces your portfolio to balance itself towards the cheaper assets without you even having to do any research. So over 2008 if I perform the same strategy I will end up buying more equities that I did last year and fewer bonds and commodities automatically, which would be the correct thing to do even from a “market timing” perspective. In that sense I will be buying-low-and-buying-less-when-prices-are-high.If you are one of these investors then stay the course! As the worse thing you can do to the strategy (and your portfolio) is mess with that arrangement, because then you will find that things will not balance out over time and you have inadvertently become an active manager. I would advise you to keep investing regularly throughout 2008.

However as I have said previously you will not be able to follow this strategy if you invest solely in Malaysia. This is because we can only mainly buy equities. So what can the rest of us do?

This brings us onto the next reason why it shouldn’t be necessary to look for timing - Money Management and Bet Sizing.

Money Management and Bet Sizing

Now here I am going to argue that the second reason why you don’t need to guess where the market is going is because the secret to being a successful active manager is that you don’t put yourself in a position where you have to do so. So how is this possible?

Money Management

Real traders will tell you that being good at trading doesn’t involve knowing when the market will go up or what to buy. It involves cutting your losses and letting all the other trades take care of themselves. Although there are many many books on how to develop a trading system, in a way it doesn’t really matter what system you use to enter your trade. The important thing is just knowing when to exit.

For example, a simple stop loss strategy involves selling when the prices close below the low of the 3rd previous candle. This applies whether you are trading by the minute, hour, day or week. So assume that I have bought a share on Monday and am trading by the day. I will sell my position on Wednesday if the price closes below the lowest price which traded on Monday. It’s as simple as that.

Now anyone who follows this simple rule will be out of the market very frequently. Yes, it can be frustrating, and yes, your trading commissions will eat into your capital, but you will not get wiped out and the rate of your losses will slow right down enough to let the winning trades have a chance to work their magic.

But you will not be able to make money if you follow this strategy alone. This is because trading commissions will eventually eat up all your capital, so what can you do to help the situation?

Bet Sizing
Stopping yourself out all the time is not profitable unless you enjoy slowly bleeding to death. You have to do something else to make sure that the money you lost is more than made up by the winners. From experience, I can tell you that just leaving the winners as they are would not be sufficient as eventually they too will get stopped out. It will prolong the inevitable because you will make small amounts, but eventually commissions will eat them away too. So, you should add to your winning positions. This will increase the chances of you making even more money as you are buying into a stock that is showing strength. A simple rule involves just taking the money you obtained from closing out your losing trade and then putting it into the ones which have not yet been stopped out. I personally will just add however much money I get across all counters that are still making money. So, say I sell a share and get $100, and I have 5 shares that haven’t been stopped out yet. So I will add $20 to each share. Simple as that.

Now I dare say that if you follow this system you will make certainly make money. In fact, I even know pure technical traders who just buy everything without even investigating the companies and spend all their time cutting out the losers and adding to the winners without even so much as looking at the index or reading any report or newspaper, or making any guesses over where the market will go.

Conclusion

As you can see, either by employing a diversified portfolio and just adding to it regularly, or being more active and selling the losers whilst adding to the winners, you are automatically disciplining yourself to manage your money without even knowing where the market is headed.

But remember that in some ways it’s never really the strategy that works or doesn’t. It’s your application of it that makes all the difference. The most important thing here is to stick to your system and not deviate. Most people fail to do this and lose money.

Happy Trading!