What are the 5 pillars of winning consistently?

The '5 pillars of winning consistently' is a systematic approach anyone can follow to develop and maintain an edge in markets where the following conditions are ASSUMED TRUE:

  1. Market participants have imperfect, incomplete information
  2. Market outcomes are unknowable in advance
  3. Market outcomes are probabilistic
  4. Market 'pricing' is affected by the action and/or inaction of market participants
  5. There are winners and losers

We will examine the 5 pillars in more detail using a theoretical security called ABC company. 

1st Pillar: Fundamental Analysis

This is the first step before risking cash on any investment/trade. It is also the most likely to be overlooked, skipped over, taken lightly, or lazily ignored. This is the equivalent to doing your homework in grade school. One must identify and understand the business, industry, and sector a firm operates in. Once understood, you must identify the key drivers of that business's success and failure. Ideally you want to be able to answer the following questions: 

How does ABC company make money? How much does it cost ABC to produce or provide their core products/services? Is ABC company's profit margins inline, better, or worse than the industry? Are those margins increasing(decreasing)? Who are ABC company's customers? What would drive ABC's customers to pay more(less) and/or buy more(less)? What are the best(worst) conditions for the ABC company to operate in? Which of those conditions is most likely happening currently? 

The purpose of this exercise is to get a 'feel' or understanding of the intrinsic value of ABC company thereby allowing one to formulate a basis of comparison of ABC company's 'value' to its 'price'.

2nd Pillar: Quantitative Analysis

Both an alternative, and complement, to fundamental analysis, this is applied mathematics used to identify exploitable market anomalies.

These anomalies often involve identifying mispricings related to: the probability of an event occurring or not occurring, the statistical relationship between assets, differences in intrinsic (fundamental) valuations etc.

Practically speaking, you want to be a seller if market prices for an asset (risk factor) are overvalued relative to an intrinsic value estimate, and you want to be a buyer when market prices are undervalued relative to intrinsic value.  The depth of this subject cannot be addressed in a short paragraph. More in-depth topics are discussed on this blog, and other public resources.

3rd Pillar: Market/Investor Sentiment Analysis

This is the most difficult to describe and apply to your investment decisions because there are no hard and fast rules that will apply in all situations. Generally this is a skill that is developed over time and experience. However, developments in computing power, data aggregation and manipulation, and machine learning have created opportunities to systematically quantify sentiment. There are firms who specialize in this space. 

Essentially, your goal is to identify and understand how the other market participants 'feel' about ABC company, the industry, and the sector. I've chosen the word 'feel' purposefully. All markets, where large sums of money are at risk and the capital allocation decisions are made by humans, are inherently 'emotional'.  By identifying other market participants' emotional state(s), you can make an educated prediction about their next investment action given a particular market state. 

Example: ABC company has struggled in the past, with poor fundamentals reflected in the price chart over the last 2 years. As a result ABC company's stock price is trading near historical lows. You observe investor sentiment is extremely negative based on analysis of financial 'news', Twitter, SeekingAlpha etc.

However, you have identified key industry drivers that are projected to improve. ABC company stands to benefit directly from these 'tailwinds'. Additionally, your research has shown ABC company is already benefiting based on the last 2 quarterly earnings reports. The stock has little interest from investors as evidenced by the low trading volume and lack of direction. You decide that investor sentiment has given you a discount entry price and 'pull the trigger' on the investment and buy.

Fast forward 6 months and your initial investment has appreciated 30% over the period outperforming the market in spite of negative sentiment. Analysts have caught up to you and are now saying that ABC company is poised to grow in the future, and as investor sentiment changes, a new wave of retail/institutional buyers comes in pushing your investment even higher. Congratulations, you successfully 'picked a bottom' in ABC stock.

4th Pillar: Risk Management

The most important component to winning consistently is managing your risk. There are several approaches to this CRUCIAL pillar but they all boil down to the following keys.

  1. How many times can your investment decision be wrong/money-losing before you 'blow-up', or otherwise run out of cash?
  2. How much do you profit on your correct decisions vs. how much do you lose on your incorrect decisions? 

This description is intentionally broad because the right answers depends almost wholly on your investment strategy. For example, some strategies seek small profits at an incredibly high win % to overcome rare but significant losses of low probability. Other strategies make huge, significant profits at a low win % to overcome frequent, small losses of high probability. Ideally, whatever strategy you choose, your 'bet', or capital at risk, will be determined according to a risk/reward structure like the Kelly Optimal Betting Strategy.

Example: ABC stock is trading at $10. You want to buy the stock because your research has shown ABC has a high probability of appreciating $3. However, you have determined that your investment thesis will be proven wrong if the stock price declines to $9. If that happens you will sell out of your position no matter what and not risk further loss. In this scenario you are risking $1 of potential capital loss for an expected $3 capital gain or 1:3 risk/reward. (Note: Conventionally the risk/reward ratio is often written backwards i.e. 3:1 risk/reward ratio still means risking 1 to gain 3). This 3:1 risk/reward structure will work as long as your investment decision has a probability of success slightly greater than 1 out of every 3 trades. If the risk/reward ratio is 2:1, then you need to be 'right' a little better than 1 out of every 2 trades. Again, the optimal ratio is wholly dependent on your investment strategy.

Once your strategy is rigorously defined, remain DISCIPLINED as the underlying mathematics will provide the edge you seek, as long as you adhere to your strategy's risk management rules.

5th Pillar: Evaluation

Think 'Scoreboard' or 'Grades'. This is objective and requires you, the investor, to document every trade, every investment, the price, the date, why you made the trade/investment, the outcome, the gain/loss, what you may have done differently, what did you overlook, where were you right (wrong).

Ultimately, the purpose of this step is to calculate your profit and loss (PnL), both gross and net of all applicable fees and taxes, and systematically evaluate your investment process so that you may learn from each outcome and improve your probability of success (profits). It requires lack of ego as the only way to improve your PnL is to ruthlessly grade your failures and your successes. In the end, the goal of any trade or investment should be profit. If you don't know if you are winning or losing then you have no foundation from which to improve. If you aren't keeping score you simply aren't playing the game. 

For queries contact me at bcr@blackarbs.com