The ideal investor

The core element of the framework for applying Stock Trends indicators in a trading plan is being systematic. Systematic trading systems are methodologies that protect the investor from themselves as much as the market volatility. Learning how to interpret and apply trend following applications implements the basic principles underlying Stock Trends to our trading plan within the constraints and goals that every investor must define for themselves.

A Wall Street Journal column by Jason Zweig this past week points to a sage piece of investment wisdom from Charles D. Ellis as he addressed the Empire Club of Canada in a speech 33 years ago (See Investment Policy and the Competent Stranger). Harvard and Yale-educated, Ellis went on to found the investment consulting firm Greenwich Associates and became a prolific author of investment books and articles. His investment wisdom basically revolved around the conclusion that investors cannot beat the market, and that low-cost index funds are the optimal investment vehicles for investors - something he advocated in his popular book, Winning the Loser’s Game.

Of course, the thesis behind Ellis’s wisdom flies in the face of Stock Trends’ active trader approach and why you are probably here. But when you examine the elements of what Ellis describes as an ideal investor in his 1988 speech we can see that the foundational differences between a successful active investor and the successful investor Ellis defines are not that clear cut. The only difference is that the passive investor has adopted the costs and risks implicit with index investing while the successful active investor has adopted the costs and risks associated with buying and selling securities directly.

Ellis defines the ideal investor (he specifically refers to the ideal client in his speech but this is a difference of semantics based on a third party relationship) as someone who is able to identify his/her own financial needs and goals from which an investment plan is established. That plan will depend on the risk profile of the investor and the capital resources available, both of which are variables that change over time. The challenging aspect of this framework is the investor’s commitment to the agreed-upon plan and the timeliness and appropriateness of any changes precipitated by a thoughtful review of the plan. The investor must truly know themself and be honest about their financial goals and how their financial resources align with a chosen investment plan. Ellis’s ideal investor must have the emotional discipline to set and adhere to a long-term investment policy. The investor must know their emotional situation and emotional constraints to avoid the inevitable strains the market places on participants.

A systematic investor must go through the same process. Every trading plan is shaped by the available capital and risk profile of the individual investor. What differs most significantly may be the trading capital required. The buy-and-hold investor has a number of investment products to choose from that provide diversification at a low cost and overhead. The funds make it easy for small investors to get a start at implementing a sensible long-term investment plan. Because the systematic investor has to exercise their own position sizing and diversification the capital needs are generally higher. The unfortunate consequence is that many new investors often try to shoehorn a systematic trading plan without having sufficient capital to weather normal drawdowns. Worse, the market often destroys new investors with neither an investment plan nor adequate capital. Well, maybe they have a plan, but it’s basically a hope and a prayer.

The low-cost feature of index investing is a great sales feature for all investors, new and old. But the risks associated with these products are not so generally understood. A considerable problem with any buy-and-hold strategy is the alignment of the investor's own time horizon. Apart from the emotional rollercoaster ride to which even a diversified portfolio can submit the most conservative investor, there is always the issue of the changing financial needs of the investor. An extended bear market and the associated drawdown are often amplified by personal time horizons. An investor may be approaching retirement age, for example, just as the markets collapse. It’s hard to stay-the-course when immediate concerns and a plummeting investment account coincide. Drawdowns matter and the timing of them are not easily reconciled with an investor's real-life experience. This is a risk that should always be addressed when an investor is weighing the options of being a passive or an active investor.

A successful active investor - most specifically a systematic active investor - will construct a trading plan that recognizes the emotional challenges of the market cycles and implements a strategy that minimizes drawdowns. Of course, market outperformance is always a primary goal but excess returns often can only come with the same kind of drawdown risk that comes with the buy-and-hold approach. The road to riches is never easy.

Trend following investment plans have a feature that does actively limit investor drawdowns. Indeed, a successful systematic trend-following strategy puts the investor in a position of earning excess returns by limiting losses on individual trades and exiting bear markets. While actual alpha comes from riding the returns of excess fat-tail returns (the winners!), portfolio market outperformance would not be present were it not for the success of a strategy to limit losses on losing trades and exiting bear markets. That is, quite simply, the investment plan.

Like Ellis’s ideal investor, the systematic investor must properly make and periodically evaluate a trading plan that optimizes results according to investor capital and investor needs. Like the investor Ellis elevates, the systematic active investor must understand how the trading plan will contribute to the preservation and growth of capital by extricating the investor’s emotions and allowing the system of buying and selling to operate effectively.

Stock Trends is a trend follower’s toolset that enables investors to systematically identify stocks that are trending, as well as relative price momentum and other qualitative features of market data. It also gives guidance toward the prevailing market sentiment. Building a trading plan demands the investor develop some basic money management skills so that whatever toolset is used to activate trading signals there is a proper accounting of the established investing parameters. The result should always be absolute knowledge of when and why a trade is to be executed. In particular, a systematic trader must know the exit signal before each trade. A trading system without a defined exit strategy is a recipe for failure.

We all would like to be an ideal investor. Whether of the ilk that Ellis describes or the disciplined systematic investor that Stock Trends promotes, the principal characteristic is the same. Know thyself, understand the market and protect your capital from its inevitable challenges to your wealth, and create a long-term investment plan that will guide you to your goals. It takes thoughtful planning and discipline to succeed at most things in life. Wealth creation is no different.