While you may be starting to understand your retirement situation a little clearer, it’s critical that you now work towards the next phase and understand how much money you’ll need to live out the life you desire. It’s not important to comprehend how you’ll get there just yet; rather I’m going to help you recognise the variables that affect capital growth and retirement. When it comes to growing capital, there are 6 factors that influence returns:

1. Your capital base, or how much money you have to start with.
2. How much capital you plan to add to the capital base over time.
3. The length of time you have to invest.
4. The rate of return.
5. The effect of compounded return.
6. Inflation.

Each of these factors will have a direct effect on how much money you’re left with when the time comes to retire. Let’s look at each of these factors independently.

Before you read any further, write down right now what you think the average rate of inflation has been in Australia over the last 26 years. Ok, read on.

The capital base

The more money you have, the easier it is to invest. Quite simply, a large capital base will allow you to take less risk and compound a larger amount. For people with a small capital base, you may have to search for a greater return which inevitably comes with greater risk.

How much capital you continue to invest

This adds up. The more money you can consistently put aside for retirement, the more likelihood you’ll have more money when the time comes. Money consistently added to money creates compounding.

The period

Whether you have 10, 20 or 30 years until you retire; the period of time you have to invest will make a dramatic difference to the size of your capital base when it comes time to retire. The earlier you start on the journey, the bigger the pie at the end.

Rate of return

The rate of return or acceleration rate at which your money grows has a huge effect on growing capital. Just a few percentage points here and there each year can make 100’s of 1000’s of dollars difference over one’s investing lifetime.

Compounded return

Albert Einstein was once quoted as saying “the most powerful force in the universe is compound interest”. Compounding is so powerful in fact that in some counties and religions it is actually illegal to compound money (for another time). I’ve spoken about the subject of compounding money in the past and I believe it’s the ‘Holy Grail’ or crux of active investment.

Inflation

Your money is losing value by the day. As inflation takes affect and goods and services become more expensive, your money becomes less valuable. While milk and bread may remain roughly consistent with CPI, the chances are that when it comes time to retire, that you’ll be spending money on travel and other luxury goods that may rise faster in price than the CPI rate. This needs be taken into consideration pre retirement.  

Calculating your inflation rate

More importantly, you should try to calculate your own inflation rate and not just accept the general and averaged ABS CPI figure as being applicable to your situation as an indication of inflation. Depending on your lifestyle, your age group, where you live and the types and size of products and services that comprise your expenditure there is a high probability that you have a different inflation rate to the official CPI. In fact, you may come to the conclusion that CPI is meaningless as a measure of inflation for you when you read the following facts that you simply will not find any politician referring to!

Consider the following calculations which are sourced from the Australian Bureau of Statistics (ABS). From 2004 to 2010 the absolute increase in CPI was 19%, or 2.94% compounded p.a.  CPI measures changes in prices, not what households are spending.

However, the average household expenditure increased by twice as much at 38%, or 5.58% compounded p.a. over the same period across all goods and services, all households (there are many categories), all age groups (of which there are 6 sub categories) and all states (capital cities and country side). However the biggest household expenditure increases were in housing costs (6 sub categories) which, according to the survey, comprises 16.1% of household expenditure (yours may be higher, or lower) at 7.64% p.a. with the sub categories of ‘mortgage payments’ rising at 9.78% p.a. and ‘rent’ at 9.03%. These are more than 3x higher than CPI!

So should you use CPI or your household expenditure as your proxy for your inflation rate? In my view the household expenditure is closer to the mark. There are also other sources that can be researched on the ABS website such as the Analytical Living Cost Index.

The other major categories are listed below.If you think that this may just be a recent phenomenon then think again. Here are the annual compounded rates of increase in household expenditure from 1984 – 2010 which, while lower, are still relatively high.

In comparison CPI has compounded at 3.72% p.a. from 1984 – 2010.

I’m sure that most would have written down an inflation figure closer to 2.5% or nearly half the rate at which household expenditure has been rising over the 26 years to 2010. So what’s the difference between 2.5% inflation and 4.84% over 28 years? Well a dollar in 1984 is worth 50.6 cents today with inflation at 2.5% but at 4.84% it is worth 26.6 cents!

It should also be considered that the policies being used by central banks in Europe and the USA to ‘print money’ will most likely lead to higher rates of inflation in the future.

The other part of the equation is how incomes have grown in relation to expenditure but that is more relevant to calculating your current situation than your future retirement position.

How does knowing this affect our view of how we should go about planning for our futures and our retirement?

Retirement tables

I’ve prepared three performance tables so you can identify a likely outcome at the point of retirement. Here are some explanations about the tables. Table 1 has low compunded returns (0% – 5%), Table 2 medium (6% – 12%) and Table 3 high (15% – 30%) returns, more for comparison than being realistically achievable. Whilst even higher returns could be considered it is an extremely low probability that they could be sustained over 20 years.

It’s impossible to take every investor’s capital base and investment period into consideration so to give an idea to readers I decided on a sample investment period of 20 years, taking into account starting amounts of  <$200,000 and a compounded annual inflation rate of 4%.  I have used two separate columns for each percentage return so you’re able to understand the difference between the actual performance (Tomorrow’s $) versus what the return will equate to if your inflation rate averages 4% for the next 20 years (Today’s $).

Also included for each starting amount is an option to add $100 per month, unindexed for inflation.

Table 1
Table 2
Table 3

Click here to download the Compound Growth Tables spreadsheet should you wish to edit the parameters to your unique situation.

Once you have an idea of how much money you’ll need in retirement you have taken a big first step in your retirement planning, the next being how to solve the  challenge of achieving your desired returns. We’ll make an attempt at tackling this next week.

Every one of us has a different idea of what life in retirement may look like. Some will plan to fulfil their life long dreams, while others are comfortable spending time with family and friends. Whatever life you plan to lead in retirement it needs to be a choice rather than it being forced upon you. This requires that you financially plan ahead. There is no truer statement than “The financial actions you take or don’t take today will directly affect your future”.  This is not a throw-away line. The decisions you make today require an action!

Next week I’ll discuss Growth Vs Protection.

Here we go again. Another round of fear, uncertainty and doubt (FUD). One might argue that FUD  always exists, it is just the amount of energy that it is afforded relative to the amount of energy that confidence is afforded that determines whether positive or negative holds the sway.

Then the question usually begs what causes the FUD, or confidence, and, is it warranted? In my opinion, when it comes to investing, knowing and understanding what the causes are doesn’t matter at all to each of us at an individual level. All that matters to us individually is that we have an alert mechanisim against which we can act accordingly.

When ‘confidence energy’ is higher than ‘FUD energy’ people feel good and make decisions that are aligned with outcomes that are expected to be positive. This is when people DO things. And when ‘FUD energy’ is higher, decisions are aligned with outcomes that are expected to be negative. This STOPS people from doing things. Why would you do something if you expected a negative outcome?

Feelings eventually change from FUD to confidence when the herd (I include leaders of political ilk in the herd) realise that the outcome will not be as negative as what was expected and that it has all happened before. That may require some changes in some or many of the variables that play a role in the given environment.

The fear at the moment is about sovereign debt default, as it was at times last year and at times the year before that. Like sovereign debt default has never happened before! May I suggest that you do some reserach on sovereign debt defaults. You will find that it is far more common than you realise and has been occurring for centuries, even in large economies far larger than Australia’s.Click here to determine the size of different economies. Click here to start your research on historical sovereign debt defaults.

However, be that as it may, being a bit more informed is NOT going to change confidence levels – there are just too many variables involved than just knowledge about causes. That is why being able to read sentiment is a far more practical skill than having more fundamental  knowledge about companies and economies. Determining net overall sentiment takes all the variables into account and leads you to the result of the causes. And the net result is far more important than knowing the cause when it comes to your financial investments. Knowing the result is achieved via interpreting price action on financial markets - the envioronment in which the net of all the ‘FUD energy’ and ‘confidence energy’ is accutely measured.

At the moment ‘FUD energy’ holds the sway in the short term. And when ‘FUD energy’ holds the sway one must interpret the financial markets on a day by day basis to determine what action to take to protect one’s financial investments. And when sentiment turns again in favour of ‘confidence energy’ one must have a plan to act. See my analysis below on the current status of financial markets.

PS: I am holding a webinar tonight, Thursday 10th May, at 7pm AEST that will discuss the best Managed Funds performance in Australia over the last 10 years, how you can handsomely outperform them and how you can use a short daily process to determine the net balance of ‘FUD energy’ versus ‘confidence energy’ and what action you can take in your portfolio. Click here to watch a recording of the webinar.

All commodities are weaker on the back of weaker equities around the world. Gold has fallen below a key support zone of  $1600 – $1626. The next support zone is the $1525 – $1550 zone where there is also a major horizontal support level. If that zone doesn’t hold then $1450 – $1475 may be on the cards. 

With Copper, the $360 – $365 support zone needs to hold to halt this down movet to turn and take on the $400 zone again. If it doesn’t hold then the next support zones are around $350 and then $325.

It is a case of the US$ against the world at the moment as it strongly maintains its safe haven status despite all the hurdles that the US economy faces. It is nearly a lone green line in the table below.

The S&P500 found support at the 1340 level after completing a lower high above 1410 and making a new short term low below 1360. This indicates a short term change in trend to down. The question is whether it will turn into a medium term and longer term down trend.  SPA3 has indicated a ‘sell’ in the medium term – the red down arrow – as has the Nasdaq Composite but not the Nasdaq 100 nor the DJIA.

The 1340 level is the 23.6% Fibonacci retracement level of the runup from early October 2011. A very strong rising market would find support and rise form here. A strong rising market would find support around the 38.2% level which at or around 1290.

The two blue horizontal lines show a strong horizontal support / resistance zone between 1300 – 1320.

These are all key support levels one of which should hold for this rising trend to potentially continue to make a new high above 1422 and then rise to the next two targets of 1450 and then 1483 (138.2% Fibonacci extension).

S&P 500

Since late March the All Ords started slightly outperforming the S&P500  – see the RSC graph below. This was due to some of the Australian larger cap stocks such as our banks starting to make a move. The small caps lead the charge from mid December and now there are signs, although small, that larger cap stocks are starting to strengthen. If they do and then the smaller caps rejoin the campaign (they are due to having had a healthy retracement) we could be in for a jolly time in equity markets. However, there are some headwinds to get through first.

We have had 3 ‘big red’ trading sessions over the last week but everything known to man gets tested. And this equities trend that started late in 2011 is getting tested right now. If it passes the test then that will be hugely positive for equities so don’t quite start running for the hills yet. I’m not saying it will pass the test just that the evidence at hand right now is still with the up trend in the medium to longer term and we should hold our nerves and stay with that decision until we have evidence to the contrary. Suggesting otherwise right now is a pure guess.

The XAO closed below the 23.6% Fibonacci retracement level yesterday. It needs to confirm or deny that break below in the next couple of trading sessions by remaining below or going lower. If it falls further then finding support around the 4253 zone would still support the up trend that started in early October 2011 as a 38.2% retracement is quite healthy provided a new high can be made from there.

If the 38.2% 4253 area doesn’t hold then the All Ords could retest the 4100 – 4200 zone (blue rectangle) yet again. This would yet again dent confidence in equities that would take some time to rebuild.

Keep an eye on these levels of support and resistence.

The SPA3 public portfolios continue to outperform the market by a large margin. See the performance table below that shows the comparative compounded annual returns.

All Ords

Share Wealth Systems provides more detail on all of the above items at our eUGMS. The eUGMs are monthly multimedia presentations available to Share Wealth Systems members only.

The figures used in this Active Investor are based on data prices as of: 09/05/2012

Most people have no clue as to whether or not they are on track to retirement. One thing is for sure, if you don’t plan ahead, you’re almost certain to fall short when the time comes. Over the next 3 weeks I’m going to share my views on some of the more important factors that we all need to consider pre retirement.

So how much money do you need to retire? Of course the answer to this question depends on a number of variables like when you plan to retire, how long you want to continue working and what type of lifestyle you’re after when it comes time to say goodbye to the working world.  So as an introduction, this week I thought we’d look at the factors that will influence the right time and how much money you’ll need in retirement. Here we go:

1. The age you want to retire. The age you would like to retire and the age you can afford to retire could be worlds apart. Obviously the earlier you plan to retire the more money you’ll need. This question should be tackled many years in advance so you can work backwards and understand how much money you’ll need in retirement.
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2. Life expectancy. Life expectancy needs to be taken into consideration before making a decision to retire. According to United Nations Statistics, Australians are the 6^th most likely Nation to live the longest (you can see entire list of statistics here). For women, the average life expectancy is 83.6 years while for men it is 78.9 years. But unless you have a reason to believe that you won’t be healthy, the likelihood is that you’ll live into your 90’s because these figures are averages. The longer you live the more money you’ll need.
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3. How much you already have saved. Compulsory employee Superannuation contributions introduced by the Australian Government in 1992 could be the most important legislative change in the last 50 years. While Union employees had access to super years before the introduction of compulsory superannuation, the legislative changes allowed every working Australian to earn super. You can start accessing your super at the age of 55 and by the time you reach 65 you can either take it as a lump sum or keep the money in super and ideally growing. For many, your super will be the focus of your retirement nest-egg.
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4. What lifestyle you plan to lead. When you retire, you’ll have more time to spend money. You may decide to travel the world, buy a boat or help out your kids and grandchildren. If this is the case, you’ll need a healthy capital base. For those who believe they can live on less than they currently live on now, experts suggest that you’ll need at least 80% of your current salary to maintain a lifestyle. Of course what type of lifestyle you want to live will have a huge effect on this figure.
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5. How quickly your money will grow before retirement. This variable will be the #1 factor as to when you can afford to retire and how much money you’ll have in retirement. I plan to talk about this in detail over the next couple of weeks but be assured that small compounded percentage gains over a long period equals a big number.   For example, if you invest $100 a month, unindexed, for 40 years at a 5% annual return, the $48,000 deposited will grow to over $152,000 but a measly 3% more (8% annual return) will grow to over $351,000. Compounding is the holy grail of investment.
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6. How quickly your money will grow during retirement. The average annual rate of returns on your money is likely to become lower as you move closer to retirement. The closer you move to retirement and during retirement the more likely you’ll be to consider lower risk investments so your capital can be better protected.  However, you will have more time to manage your investments so you may decide to raise the bar and aim for DIY type returns.
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7. The inflation rate. Inflation is the rate of price rises of goods and services in a country’s economy. As inflation rises your money becomes less valuable and you’ll have less purchasing power. Say for example you plan to retire in 30 years and that you want to have a million dollars on retirement. Assuming that inflation rises at an annual average of 3% you’ll actually need $2.4 million in today’s money to compensate for the rise in price of future goods and services.
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8. Do you have any debts? If you have a house mortgage or other debts you’ll need income to support repayments. If you don’t have income in retirement you may consider de-leveraging your overall financial position. Relinquishing debt may be important when moving into retirement.

The financial actions you take or don’t take today will directly affect your future. If you are relatively young you may decide on a more aggressive approach in order to grow your capital faster. As you become closer to retirement, you may consider becoming more conservative. For most people it’s frightening to think how much money you’ll need to maintain your current standards of living in retirement. But before you run for the hills and fret, let me give you some examples of what type of returns are needed (next two weeks).  So next week we’ll get more into the numbers. Just remember, retirement doesn’t have to be achieved overnight but it does require planning.

As traders and investors we need to learn from our mistakes. This is why failure is so important.

Most do not learn from their own mistakes repeating them many times over. Some do learn from their own mistakes but the really wise person learns from the mistakes of others and takes the footsteps to greatness short-cutting the learning process dramatically.

General George S Patten once said, “You do not measure a man by his success, the true measurement of a man’s character is how high he bounces after he falls down”.

Or this one from Thomas J Watson CEO of IBM from 1914 – 1956: “Would you like me to give you a formula for… success? It’s quite simple, really. Double your rate of failure. You’re thinking of failure as the enemy of success. But it isn’t at all… you can be discouraged by failure — or you can learn from it. So go ahead and make mistakes. Make all you can. Because, remember that’s where you’ll find success. On the far side.”

This short 1 min 18 sec video provides some examples of people that achieved great success after great failure.

In short, you don’t need to fear failure. You can redefine failure in a way that you look forward to embracing it when it comes along.

One can only honestly acknowledge a mistake if one has rules and processes against which to measure execution. If you have no rules to break then, by definition, you cannot make a mistake and rather an unsavoury outcome becomes the only definition of what a mistake is. The unsavoury outcome also becomes the fault of the market, or the particular environment in which you are executing.

Facing the truth is necessary to prevent making repeated mistakes, especially when trading. Truth is necessary at all levels of trading. It is just as important to the novice trader as it is to the seasoned professional. If you can truthfully ask yourself the tough questions, you are sure to find the answers. This requires honesty with one’s self.

There is a saying that goes “the truth shall set you free”. To learn from mistakes one needs a structure within which a mistake can be objectively defined and when a mistake is made to write it down. With respect to trading write the mistake down in a trading journal and then also commit to paper what can be done to ensure that the mistake is not repeated in the future.  The process of committing to paper ensures that the trader has to come face to face with the plain truth and what they will do about it. If this is not done the trader’s current process will justify away the mistake as somebody/thing else’s fault. No further action is taken, the opportunity to learn from it is lost and hence the mistake is repeated in the future.

Please understand that it doesn’t take knowledge to do this on an ongoing basis. It takes desire, commitment and discipline. It takes courage to face up to yourself and take yourself on to rid yourself of bad dysfunctional habits and instil new good habits that are functional for the environment of trading the market.

Learning from mistakes is one of the reasons that trading with a mechanical system is key to learning how to trade successfully. A mechanical system doesn’t define a loss trade as a mistake. The trade is only a mistake if the rules were not followed. It redefines what is right and what is a mistake, with respect to trading.  And trading is more about eliminating mistakes than it is about being right.

So embrace failure and learn from it.

International equities markets had a good run since mid December to mid-late March. A retracement was inevitable. Mainstream market commentators will have their myriad of hindsight reasons why the market has fallen over the last week or so and will extrapolate the bad news. That’s their job. Along with this will flow all the predictions, good and bad but mostly bad, based on what appears to be solid sounding and convincing logic.

The fact is that nobody knows what is going to happen in the short, medium or even long term. So we have to go on the facts that lie before us. What are some of these facts?

Firstly, markets do not rise, or fall, in straight lines, regardless of after-the-fact reasons that are apportioned to why the rise or fall occurred! Secondly, low volatility periods follow high volatility periods which follow low volatility periods, and high volatility is synonymous with falling markets and low volatility with rising markets. Lastly, nobody knows with any certainty WHEN any price action will occur that they may anticipate and could be out by weeks, months or even years.

Taking this subset facts into consideration, the S&P500 rose some 22% from the end of November to early April while the Volatility Index (VIX) fell 58% from above the ‘overbought’ level of 28 to below the ‘oversold’ level of 15. Similar analysis can be conducted on all the international equity indices.

OK, so a retracement was inevitable and it has started. Now the big question is whether this is just a retracement in a market that will continue to rise in the medium term or whether it is the beginning of a bigger fall from which active investors should step aside?

To find the answer becomes a day by day proposition as different kinds of support levels are examined in different timeframes. As you will see from the chart of the S&P500 below the rising trend is still in tact and could remain so for the longer term horizon even with further falls in equity markets. However, the short term trend has changed to down.

From the analysis below, based on the evidence at hand to 11 April market closes, it is not yet time to step aside but the key support levels discussed below should be watched closely. These will tell you whether to “sell in May and go away” or to remain invested during this period for 2012.

Gold and Silver are still under the control of the fall in their prices that occurred during 2011 both ending with December lows.

Silver is stuck in a range between $31/$32 zone and $37/$38 zone which are the 23.6% and 50% retracement zones of the 2011 fall. At $31.50 Silver is at the bottom of this range so expect a short to medium term run-up to near the top of the range, but at least to $36. A fall below the support zone of $31/$32 would be very bearish for Silver.

Gold is range trading between $1600/$1620 zone and $1770/$1800 zone which are the 23.6% and 61.8% retracements zones of the 2011 fall. $1660, where Gold is right now, is at a critical short term indecision point where down trending and up trending resistance lines have collided. Keep an eye of the next 2 -3 days price action to determine whether buyers or sellers will be in control in the near term. However, being near the bottom of its trading range, expect a medium term rally towards the top of the range. A fall below the range support zone of $1600/$1620 would be bearish for Gold.

Brent Crude Oil is trading near the support levels of an upward rising channel which should see it rise back towards the $127 – $128 zone. There is significant resistance at this zone so a break above would be very bullish.

Copper has yet again failed to break above the strong resistance zone around 400 and has retraced back to a strong support area around 360. A fall below 360 will be bearish for Copper and a rise above 400 bullish.

The recent high of 1422 for the S&P500 fell just short of a long term resistance and Fibonacci extension zone of 1440 – 1450. It has now retraced to its first support zone of 1360 being the 23.6% retracement of its run-up from 25 November. Its next support zone is the 38.2% retracement zone which is around 1320. These areas as clearly shown by the magenta lines on the right side of the chart below.

The 1300 – 1320 zone is a very strong horizontal support and resistance area as shown by the blue horizontal lines in the chart.

Very strong bullish price action will find support  at the 23.6% level and strong bullish price action will typically find support at the 38% level. The 50% retracement level is also shown. Whilst retracements to this level are very common in stocks a retracement this low in an index will typically signal a change in the medium term trend and possibly the longer term trend. However, the long term trend can still remain in tact with a fall to the 50% level but this level would need to hold.

Hopefully it is obvious from the chart that any continuing weakness in the S&P500 below the 1290 – 1320 zone will be a clear signal to step aside from equities until a base is formed and another upward surge begins.

SPA3 users need to keep an eye out for a High Market Risk signal to occur for the objective signal to step aside from the equities environment until the next Low Market Risk occurs.

The middle chart shows the relative performance between the S&P500 and the All Ords.

S&P500 Index

There is strong resistance for the All Ords at the 4445 – 4500 zone. The solid black horizontal line and the 50% retracement line (blue line) depict this zone. The 4100 – 4200 zone is a strong support area as shown by the blue horizontal lines below the current price.

The All Ords is stuck in this zone and needs to break back above 4500 before any major advance is made. To do this the large cap stocks on the ASX will HAVE to join in. The recent strength in price action has mostly come from the small industrials and emerging companies sectors.

“Sell in May and go away” is talked about every year at this time of the year. The facts are that since 1990 this would have worked for you in 1990, 1992, 1994, 1998, 1999, 2001, 2002, 2006, 2008, 2010 and 2011. Now it hasn’t always been May, sometimes it has been March, April or May but I have skewed the count in favour of the “May” outcry and included these earlier months.

That’s 11 out of 22 years, or an even bet. What’s not discussed is when one should have returned to the market which is a far better question to ask and a far more difficult answer for most to provide. It changes from July the same year to the following March. This is why a market timing approach is required.

And, since 1990, the market rose to a higher level by the following May, except for 1994, 2001, 2002, 2007, 2008, 2010 and 2011. That’s 15 out of 22 that were higher the following May! And if you include the 1980’s there would be only another 3 years in which the All Ords was lower the following May: 1981, 1987 and 1989. So that’s 22 from 32 years that the index was higher the following May. In whose favour does the edge stand? Is “sell in May and go away” a valid market catchcry? For all investors?

All Ordinaries Index

The SPA3 public portfolios continue to outperform the market by a large margin. See the performance table below that shows the comparative compounded annual returns.

Share Wealth Systems provides more detail on all of the above items at our eUGMS. The eUGMs are monthly multimedia presentations available to Share Wealth Systems members only.

The figures used in this Active Investor are based on data prices as of: 11/04/2012

The format of the show encourages traders and investors to call and ask questions about their much loved and favourite stocks. During the show I gave my insight into the performance of following shares:

• APN News & Media (APN)
• Spark Infrastructure (SKI)
• Leighton Holdings (LEI)
• Boral (BLD)
• Worley Parsons (WOR)
• Monadelphous (MND)
• Linc Energy (LNC)
• AGL Energy (AGL)
• Northern Star Resources (NSE)
• Nido Petroleum (NDO)
• Maverick Drilling & Exploration (MAD)
• ASX 200
• ROC Oil (ROC)
• Incitec Pivot (IPL)

To see what I had to say about these stocks, watch this 24 minute cut down video.

Double click inside the box or click PLAY below to view the footage.

In December 2011, after exhaustive research that took over 2000 man hours to complete, changes were publicly introduced to the SPA3 trading system. The revisions to SPA3 have now been implemented into a simulated and single historical portfolio that has been traded historically strictly according to the revised SPA3 rules and processes.

SPA3 Research

Before we review the SPA3 simulated performance, I first need you to understand a little about the journey. By highlighting the changes between the Pre December 2011 and the Post December 2011 SPA3 Edge my hope is that you’ll be able to understand how we have improved SPA3′s performance and that you might be able to take this information into the way you trade. Read the “Research White Paper”.

From the outset of our research there were two key objectives that we wanted to achieve:

• Increase portfolio returns, and
• Reduce drawdown.

To achieve these high level objectives key technical objectives were set and researched.

While a number of new concepts and principles were adopted from the research, none were found to be more effective than:

• The introduction of an adaptive Profit Stop. Read about the Profit Stop
• A change from SPA3 Risk Profile 2 to SPA3 Risk Profile 1, which effectively means going 100% into cash during SPA3 signaled High Risk market periods.

SPA3 Risk Profile 1 (Revised Edge)

The SPA3 Revised Edge has been backfilled using Risk Profile 1. Trades have been randomly selected from the available SPA3 trades available on any given trading day that a trade was required to fill vacant portfolio positions starting from January 25^th 2001 with a $100,000 capital injection.

No new trades were taken during a SPA3 high market risk period but open trades where left open (until an exit signal was received) when moving from a low to high market risk, as signalled by SPA3. The red and green arrows on the chart below depict the change in market risk periods. Note the horizontal lines during periods of high risk where the portfolio was totally in cash.

SPA3 Risk Profile 2 (Pre December 2011)

We have continued to trade the Risk Profile 2 portfolio that was started on 25^th January, 2001 which has been traded using the pre December SPA3 Edge with Risk Profile 2 since inception. Trades have been randomly selected from the SPA3 results, in real time starting with a $100,000 capital injection. As per Risk Profile 2, trades were entered under all market conditions (both low and high risk) but with reduced position sizes in a SPA3 high market risk period, resulting in the following marked to market equity curve.

With the benefit of hindsight, we can now look closer at the performance differences and compare the Pre December 2011 Edge to the post December 2011 SPA3 Edge. While it’s not a true comparison (the Pre December 2011 Edge does not include the Profit Stop), it does provide a comparison and clear picture of what could be achieved with the revised SPA3 Edge and ceasing trading during SPA3 signalled High Risk market periods.

Performance difference

The portfolio equity curves above both started on January 25^th 2001 with $100,000. The current portfolio values of the Risk Profile 1 and Risk Profile 2 portfolios are $701,061 and $447,081, respectively. The CAGR (Compounded Annual Growth Return) are 19.03% and 14.33%, respectively compared to the All Ords of 2.6%. Yes, that 4.7% difference is a huge absolute difference over 11 years! Compounding is the holy grail of investing.

Drawdown differences

Over the life of the portfolios the maximum drawdown ever reached from the Revised Edge Risk Profile 1 and prior edge with Risk Profile 2, are -19.3% and -33.9%, respectively, compared to -54% for the All Ords.

The CAGR to maximum drawdown ratios, which provide an insight into the risk taken to achieve a return, of the two portfolios are 0.98 & 0.42, respectively, compared to the ALL ORDS is 0.048 (2.6 / 54). Yes, the Risk Profile 2 portfolio is nearly 10 times better than the All Ords and the Risk Profile 1 portfolio is 2 times better than the Risk Profile 2 portfolio.

These simple ratios provide an insight in the huge improvement in the reward to risk ratios of the different approaches and the massive advantage that active investors with an edge compared to index funds or managed funds.

The Profit Stop

The introduction of a percentage based profit target, which adapts depending on the volatility of the stock at the time of entry, was introduced in December 2011.

The key to understanding the Profit Stop is that it helps remove open trade profit from the market and allows the opening of a new position with a reset position size. So any retracement, or end of trade drawdown, that might eventuate occurs on a smaller position size, being the newly opened position. Over the life of a portfolio the repeated application of the Profit Stop and ongoing reduction of giving unrealised profits back to the market adds up to a huge difference in portfolio performance.

Three other exit signals were also introduced to SPA3 as a result of this research exercise.

Change in approach to Risk Profile

A Risk Profile answers the bigger question of “how much risk am I prepared to take with my entire portfolio?” With the research tools that we now have at our finger tips this has become more and more obvious over the last few months. Combined with the revision made to the SPA3 Edge the two have clearly combined to further improve and edge and make it far easy psychologically to trade with SPA3.

I trust that you will be able to use these insights in your situation although we have used SPA3 as an example. Of course you could always take advantage of SPA3 yourself by registering for an obligation free demo. http://sharewealthsystems.com.au/SPA_Demo.php

To quote Linda Bradford Raschke, “Goals are something that can be continuously updated and should be reviewed everyday. KNOW YOUR GOALS. Have a plan….You will always have your best odds of success in achieving your outcome if you have a written down Plan”.

Practical and wise words but evidence suggests that when it comes to the market only a small percentage of investors ever get pen to paper. Instead, the gross majority find themselves forced into making illogical, emotional and reactive knee-jerk decisions because of a lack of a written plan. Therefore, inconsistency, subjectivity, hesitation and uncertainty dominate decision making.

To me, investing should be viewed as a business that requires self-control, process, persistence, patience, objectivity, edge, discipline, desire, curiosity, consistency, confidence and attention to detail. A Plan and the trust to follow your plan can help you achieve all of the above. In the process you become an overcomer, an overcomer of doubt, fear, frustration, hesitation, uncertainty

You are in effect the CEO of this business. Your success or failure will be a reflection of your decisions which will result from the execution of your Plan. As the CEO of your business, the buck stops with you!

I’ve spoken about this subject many times on this blog but I also know that investors need constant reminding and motivation to either put to paper for the first time or to revise and update their current Trading Plan.

So I make no apologies for covering this subject again. If I can inspire just a handful of blog readers to do either then this blog will have been worth the time in writing and publishing.  More than a handful would be better but I am also realistic about how apathetic people can be when it comes to doing tough stuff like this because they want the ‘quick fix’, somebody else to do it for them or they are just “too busy” – i.e. there are perceived, or self justified, higher priority more important things to do.

So where do you start? Each section of the Plan is important but the first two are the most important and probably the two that attract the least time and effort by investors.

1. Mission Statement
   This is where any good journey starts and it deals with the question, WHY? This is about PURPOSE. This purpose will create desire and drive to stay on the journey.
   • How does it fit in with your life mission statement?
   • Are you doing this for your family?
   • Your retirement?
   • Your children’s education?
   • Are you doing this for a worthy 3^rd party cause?
   • Are you doing this to achieve skills for a career change?
   • To achieve financial freedom so that you can spend your time on a cause?
   • Is it for capital growth or income or both?
2. Goals and Objectives
   What are your financial trading and investing goals and your investing skills goals? This section deals with how much and WHAT and should detail specific periodic goals.Specifically you state here what your return objectives are and what your risk objectives are.
   • What returns do you expect to make that are aligned to your mission statement?
   • What risks are you prepared to take to achieve these returns?
   • What is the maximum risk you are prepared to take before shutting down a portfolio?
   • How much time do you have to give your business?
   • How much money do you have to invest?
   • Will you invest all my money into one strategy or will you use several?
   • How much risk will you take on each strategy?
   • Will you use leverage or not and if so, what effect do you expect to make on returns and risk?
   • Which markets and instruments will you invest in to achieve your return objectives?

   You also need to state your skills goals:

   • Do you just want to follow broker and newsletter tips or do you want to advance your knowledge and learn new skills? If so, which skills do you want to develop and what steps are you going to take?
   • What are your mindset goals? You’re certainly going to be challenged throughout your journey and what mental skills will you require to handle this mentally?
   • How will you address acquiring these skills?
3. What strategy or strategies are you going to execute?
   Are you going to shoot from the hip or are you going to develop or acquire a strategy to follow and trust? Does the strategy fit your stated return and risk objectives from the previous section.This section details HOW you are going to achieve your stated objectives and you mission statement. It answers the questions:
   • What criteria will I use to decide what instrument(s) to invest in in any given period?
   • What criteria will I use to decide to enter a position in a given market?
   • What criteria will I use to decide to exit a position in a given market?
4. Risk and Money Management
   This section identifies all the risks that you could encounter and then answers the questions of how to manage each of these risks. Risks also include trading environment such as your computer, power, software. The bigger risks have to do more with your capital and the market related risks such as:
   • Market risk and sector risk.
   • Liquidity risk.
   • Volatility risk.
   • Trade risk, etc.

   The risk management criteria and rules specified here should address how to remain within the stated risk objectives you have set in the Goals and Objectives section.

   Money management deals with how much capital to place in any given strategy and then within any given position within that strategy.

   Whilst risk and money management principles will be similar from one strategy to the next the actual rules of how much to apply will differ from strategy to strategy depending on how good an edge the strategy has and how much leverage it uses.

5. Process management
   This section details precisely when and how the Plan will be executed. What will the regular routines be that allow the Plan to fit in with all the other things going on in your life?
6. How will I measure if my business is a success?
   • Do you have a performance bench-mark? If so what is it?
   • How often will I measure my performance?
   • Is the time I invest managing my money a fair reflection of the returns that I am achieving?
   • If I fall short of my return objectives why has this occurred? Because I didn’t follow the processes correctly or because of systemic differences to what was expected?
   • Did I exceed my maximum risk objectives? If so, why?
   • What will I do about?
   • Having a plan and benchmarks allows one to conduct skills gap analysis. Filling that skills gap feeds back into the skills objectives in the Goals and Objectives section.

Failure to meet ones objectives is merely feedback on what development one needs to improve. The investor with PURPOSE and desire will find a way. The investor without purpose and desire will fall by the way.

Formulating a plan for managing money in the market is akin to writing a business plan. It is a MUST. I’d encourage you to immediately write your very own trading plan that will outline how you will approach the market. For those that already have a Plan, pull it out of the bottom draw and measure how successful you have been in adhering to it. All too often we file away our plans and only revisit them at times when someone writing a blog reminds us to! Our Plan should be most needed when we are most challenged. If it doesn’t help you make decisions when times are tough then it is simply not complete. Make sure you complete it!

To ensure that you stay the course – keep your Plan on your trading desk.

The market has been showing lots of positive signs since January. Volatility has reduced greatly and some fantastic trends have emerged in certain sections of the market.

For SPA3 users, we’ve been in a Low Market Risk period since the 13^th of January 2012. Our Plan has guided us and allowed us to expose our money to the recent rising market providing SPA3 portfolios with returns in the order of 12% whilst the All Ords have risen just 2.5%.

When (not ‘if’) the market does at some stage turn and head lower, our plan will dictate exactly when we will reduce our exposure by removing our money from the market, even to 100% cash. This is the ongoing cycle of the active investor that has a Plan.

When it comes to the market, losses are as much a fact of life as taxes and death. As humans we magnify losses and place greater weight on loss trades and the loss of money. But there are valuable lessons to be learnt right there that reach far beyond the loss trades and it’s these lessons that drive us all to grow as investors.

For most of us, success is dependent not only on what is done correctly but, also, on which potentially havoc-wreaking mistakes can be avoided. And I believe there are three core and practical principles that aid in anticipating and possibly avoiding mistakes and large loss trades. They are probability (Edge), risk management (and associated position sizing) and self discipline.

Today, I would like to help you understand that risk management is one of the keys to survival as an investor. Active Investment is a game that can be played for decades but there is only one fundamental factor that allows you to play the game – MONEY. Without capital, without the preserving of capital and without the ability to grow capital, you’re likely to become extinct as an investor.

Every trader and investor must train themselves to implement risk management principles for a vitally important reason:

No one knows with 100% certainty whether the next trade you enter will be profitable or not.

If investors have no control over the profit or loss outcome and if there is no certainty which trades will be successful, then they should focus on the only element that can be controlled – the risk of the trade and the protection of capital.

If this is done consistently with an edge then I have some very good and incredibly liberating news for you:

You do not need to know with any certainty whatsoever whether the next trade will be profitable or not.

Risk Management

There are some personal risk management questions that need be answered upfront and before we trade and these questions need to be documented into a trading plan. I know, a Trading Plan …….. , but trust me, the Trading Plan is the crux of this entire trading caper. The Trading Plan will drive you to find the answers that need to be found and will help you survive the tough times and then thrive during the good times. Like a sailor setting off on a long voyage, the Trading Plan with the necessary questions answered charts the course. And with self discipline to execute the Plan, we will hopefully arrive safely.

Here are some personal risk management questions you may need to answer.

Personal

• What is the maximum amount of money  I am willing to lose during the tough times, and does this amount fit with how much risk I plan to take on each trade?
• What criteria will I monitor to warn of the tough times and the potentially good times?
• How much portfolio drawdown can I tolerate before it becomes mentally too tough to continue trading?
• Do my risk objectives fit with the strategy(s) I plan to trade?
• What is my performance benchmark and how will I know if I am achieving adequate performance?
• How much capital should I place in each trade and when should I alter this, either up or down?

Here are a few of the everyday market environment risks we have to manage as private investors and which should all be catered for in the Trading Plan.

Market Environment Risk

• Market Risk, including market ‘shocks’
• Sector Risk
• Company Risk, including company ‘shocks’
• Liquidity Risk
• Volatility Risk
• Other: Office, Technology, Broker, Individual, System
• Money Management Risk

Risks that we can control

• Market Risk – When to have money in the market and when to have it out.
• Sector Risk – Which sectors are performing and which sectors are not.
• Company Risk – Unknown’s coming out of left field. This is controlled by monitoring the share price for a potential exit signal.
• Liquidity Risk – How much money we put into the trade making sure that there is enough liquidity to get money out, when needed.
• Volatility Risk – Ability to measure how volatile the stock or instrument is in which we’re investing, so that the appropriate amount of capital can be risked.
• Money Management – How much money to put into each individual trade considering each individual trade has a different risk. Taking too big a position size can be devastating to a portfolio.
• Exit signals – When to exit the trade.

Now I want you to understand how risk management can dramatically improve performance.

The equity curve examples below are the portfolio simulation results of 1,000 unique portfolios that, starting on 1^st January, 2000, have entered and exited trades only according to the SPA3 system (edge).  (BTW an exercise such as this can only be done with a mechanical system).

The capital injection for each portfolio was $100,000 and position sizing is based on the individual risk or volatility that each trade presents to the portfolio. Each individual line (black line) is one unique portfolio of the 1000 simulated equity curves.

Each unique portfolio equity curve and is randomly generated from the trades available on any given day to keep the portfolio fully invested with available capital at all times, according to the risk management rules deployed.

No brokerage is included in the results as the examples below should only be used to highlight the principles of risk management and money management. That is, it is the shape and distribution of the equity curves that are important for this exercise. Brokerage is included at a later stage of research such as this.

The first example includes NO risk management. Trades entered and exited in the portfolio have been followed at the time that SPA3 signals were generated, trading through all types of markets, up, down and sideways. The red equity curve is the All Ordinaries index.

The first example demonstrates that while the great majority of portfolios out-perform the market, a small number of portfolios fall below the red line. Again, there are NO risk management rules used in this example.

When risk management rules are introduced, one can visually see the difference. The exact same entry and exit timing rules used in the example above have been used in the next example below but now market risk timing has been added to the recipe and altered position sizes depending on whether it was a SPA3 low or high market risk period. This means that during SPA3 high market risk periods no new trades were entered – these are plainly seen when the equity curve becomes a horizontal line.

This example highlights the fact that all 1000 simulated portfolios out-performed the market, even the poorly performing ones.

The example below demonstrates even greater performance.  Again, the same entry and exit criteria have been used but money management rules have been introduced to decrease the risk taken in individual trades based on the amount of drawdown the portfolio experiences. This measure further improves SPA3 performance not because of trade selection but because of risk management measures.

The three examples above emphasize how critical risk management is to performance once one has an edge in the market.

If you are interested to learn more about SPA3’s risk management and performance, we would be happy to take you through a demo of what’s required to become consistently successful using SPA3. www.sharewealthsystems.com.au/SPA_Demo.php

If you are technical and interested to learn more about the latest round of SPA3 research, you can read all about it in a 60 page white paper I wrote on the improvements made to SPA3 www.sharewealthsystems.com.au/revisededge_whitepaper.php. Remember that it is a research document, so if you find it a little heavy in places, find a quiet corner and invest the time to understand what the outcomes of the research mean. By no means is the paper the end of our research. Actually, it’s just the beginning. We are continually testing new concepts in the hope of even further improving SPA3 for our customers.

After communicating with 1000’s of investors over the past 16 years, I can categorically state that the great majority of private investors’ trade with little or no risk management rules. Instead, they spend their energy and focus on building a stock picking mentality, thinking that the trades they choose alone will determine whether money is made or not. Besides such an approach being inconsistent and subjective it completely lacks the two biggest determinants of market outperformance: risk management and money management.

There’s an old seafarer’s saying that I believe says a lot, “a smooth sea never made a skilful mariner”. In a rising market we are hardly challenged and risk management becomes less important but to survive the ups and downs over your investment life, risk management rules are imperative.

Massive liquidity (printing money) is being pumped into the European and USA economies and this, combined with a low interest rate environment, is causing demand for stocks which is causing them to rise. It is common knowledge that the Australian equities market is underperforming the major equities markets around the world and has been for some time. However, the tide could be turning as some little looked at ratios are starting to signal a potential change in the sentiment towards stocks. One such ratio is the stocks to commodities ratio which indicates that stocks will rise when the ratio rises and fall when the ratio falls.

The weekly chart below shows the All Ords in the top graph, the stocks to commodities ratio in the middle graph (Relative Strength Comparison (RSC) of the All Ords to the Continuous Commodities Index) and a 52 week smoothed momentum indicator (SIROC) of the RSC.

Whilst not perfect (nothing is) there is a close correlation between the peaks in the bottom graph and the peaks of the All Ordinaries index and the troughs in the bottom graph and the troughs of the All Ordinaries index, as matched by the red and green vertical lines.

The latest turn up at the rightmost edge of the bottom graph that started in early November 2011 is potentially signalling a start of a run in equities.

Other inter-market ratios such as stocks to bonds and stocks to currency (A$ for the ASX and US$ for the USA equity markets) are showing similar signs in both Australia and the USA.

So there are signs of a potential run in stocks around the world. But what about Australian investors? Well, despite the underperformance of the ASX compared to world equities markets there are pockets of the ASX that are performing very well and active investors that have remained attentive to the stock market are making decent profits at the moment. The old saying that “all ships rise on a rising tide” doesn’t always apply. When a stealth bull market occurs one can’t just pick any stock in the hope that it will rise such as can be done in a broad raging bull market. Further skills, but simple skills, are required to find the ones that are performing that are not obvious to the herd.

How does one find these pockets of opportunity? It can either be done by:

1. conducting ‘bottom up analysis’ and scanning the entire market with a Relative Strength Comparison (RSC) filter of the stock against the overall market index. This is a standard feature in the SPA3 methodology. Or
2. conducting simple Relative Strength Comparative analysis of the ASX sectors against the All Ords.

RSC is the key technique. Let’s examine a few graphs to make the point. Firstly, the All Ords compared to the Financials sector.

The underperformance against the All Ords is indicated by the declining blue line in the bottom graph, especially since late December 2011, despite the Financials Sector not declining in the top graph. The Consumer Staples, Info Tech, Materials, ASX 100 Industrials, ASX 100 Resources, MidCap 50 Resources, ASX 20, ASX50 and ASX100 are the other notable underperforming indices, particularly the ASX50 and ASX20, which is shown below.

Note the rapidly declining blue ratio line in the bottom graph. Now compare the relative performance to the Small Industrials and Emerging Companies to the All Ords, respectively.

Since their lows in late December the Emerging Companies index, which is made up of stocks between number 350 and 600 by market capitalisation, is up 19.26% and the Small Industrials is up 13.48% compared to the All Ords which is up just 5.91% over the same period.

There have been some wonderful movers amongst the Small Industrials constituents including TRS, SUL, SDM, AAX, MIN, ACR, EHL, NWH and many more, in fact in over 30 of the 108 constituents. To make the point in a picture:

The last two trades in NWH have been stopped out with a profit stop around the peak of each move thereby realising open profits and then allowing a new position to be opened with a reset position size and locking in the profit from the closed trade. The most recent Profit Stop occurred Monday (5^th March) to exit during trading yesterday.

Indeed there have been many fantastic trades already in similar stocks that are not constituents of the Small Industrials Index or the Emerging Companies Index. Trades such as BRU, AZH, NSE (shown below) and many more.

The red arrows at the top of each peak are Profit Stop exit signals to exit on the following trading day. The most recent entry signal occurred on 24^th February to enter at 50c on 27^th February as a High risk trade (small position size). It is still an open trade. You may wish to follow this one to see where it ends.

The point is that the ‘Top Down’ RSC analysis provides an excellent insight into where the pockets or opportunity are at any given time in a stealth bull market.

Of course, market conditions in these stocks could change very quickly which is why it is necessary to engage strict risk and money management processes while taking advantage of the excellent opportunities that are in play at the moment. This would involve deploying a profit stop (to take unrealised profits into the trend in case of a change in market conditions – see NWH & NSE trades above), strict unambiguous exit signals to cut a loss trade or to protect profits when the trend changes in the stock, risk management rules to withdraw from the market when it does turn down again and precise position sizing to ensure that not too big or small a position is taken in the trade.

If the either if these indices should provide an ‘exit signal’ (see the red down arrows on the index charts above), then all trading would cease immediately.

In summary, there is opportunity in the stock market right now and it is in stocks with potential for growth. Whether this signals a broader market rally or not is still not clear but in the meanwhile there may be some fantastic opportunities for some time to come in the small to mid cap end of town.

Those that are prepared to stay the course and stay in the game according with well thought out processes ‘get lucky’. I guess that applies to all things in life.