May 25th, 2011
There’s an experiment in A Random Walk Down Wall Street in which a large number of coin tosses are recorded and graphed. Soon the graphs began looking like your run-of-the-mill stock charts (i.e., head-and-shoulders, double heads, wedges, etc.). If each coin toss was random and a series of coin tosses resembled stock charts then the movement of stocks must also be random. That’s the logical conclusion the author, Bernard Malkiel, intend his students and the reader to have. The lesson intended to drive home the idea that the best investment strategy is investing in index funds on a buy-and-hold basis rather than individual stocks.
iStockChart.com offers an online stock market simulation game that leads to another conclusion. The game’s premise is to demonstrate that “historical data is an integral part of playing the stock market …. with the game, you can test your mettle at analyzing the historical data and making strategic decisions as to when to buy and sell.” The goal here was diametrically opposed to Malkiel’s game so I decided to try my hand.
Contestants, presented with a hypothetical $100,000 and a nondescript chart are asked to either buy or sell the stock based on what they see. For up to the next 90-120 days that they hold the stock (or have sold the stock short), they are asked to make the same decision (hold your position or not). When the decision is finally to sell (or cover the short), contestants are presented with another chart but from another random starting date. Again, the decision is whether to roll over the proceeds into this next stock or skip the next. As many charts can be skipped as might be necessary until a stock appears worthy of commitment.
With so little information, how do contestants decide whether invest in the stock depicted in the chart or not? Do you look for a clear trend? the beginning of a chart pattern? Furthermore, when do you decide to sell? Is it all purely random chance? I tried a variety of approaches at first:
- All you had to do, I thought, was to figure out which stock it was since, knowing that, you’d know how the stock actually performed over the subsequent 90 days. But that was easier said than done because of the huge volume of data that would have to be reviewed.
- I thought I would pass on any chart that didn’t have a clear trend or chart pattern but it turned out that very few met these criteria and many of the ones that did turned out to fail soon after the chart started rolling forward.
It finally dawned on me! I was focusing too much on the individual stock stock chart itself and had neglected a key lesson learned long ago: 50% of a stocks movement is dictated by the market. The only relevant information in each of the charts was the chart’s beginning and ending dates. If I referred to a long-term chart of the S&P 500 beginning with those dates, I’d know whether the subsequent 3-6 months were bullish or not. If they clearly were, I would buy the stock; if the market was bearish, I’d sell the stock short; if neither, I’d pass on it and move on to the next.
By making market timing my sole investment strategy, my stake grew from $100,000 to $387,146, first place and five times greater than my runner-up after 35-45 purchases plus another 35-45 I had passed on (see the leaderboard on the iStockChart.com site)! I quickly sold the relatively few stocks that failed to prevent additional losses.
If we had invested in an Index vehicle on a buy-and-hold basis for the past 11 years we’d still be behind the curve. This game convinced me, even more than I ever imagined before, that about the only thing you need to make money in the market, even more than picking good stock charts, is knowing with a high degree of probability the market’s trend over the near future. In other words, time the market well and stock market success follows. My subscribers know that my portfolio management strategy begins with market timing.
Wow! Having known that 25-30 years ago would have saved me a great deal of money and many sleepless nights. “Better late than never”, as they say.