As this will be my last posting for 2008, I would like to express my thanks to all of you who have read and contributed to my blog. This was a new venture for me, and I am pleased to say it has been great fun and very successful. We have had in excess of 10,000 ‘hits’ to the site after just 9 weeks of ‘blogging’. I hope that the topics I have been posting have been able to assist you in some small way in your education and your trading and investing endeavours. The idea being that this blog can be a continual reference point, allowing you to refer back to the various topics in the months and years ahead. We certainly have some exciting projects in the pipeline for 2009. This blog site is definitely one of those and I will be back in mid-January for my regular weekly comment on various aspects of the market and trading and investing in general.

Like all years, 2009 will be different from all others. It will present challenges and exciting prospects and opportunities to all of us in various ways. It will reward the prepared and educated traders and investors, and frustrate those who are unprepared. Those that have a solid plan in place for engaging or perhaps re-engaging the market when the time is right, will be ready and able to take advantage of the opportunities as and when they present themselves. Those that don’t have a plan in place, or those that are sitting on portfolio’s that have lost a significant portion of their value, and are waiting patiently for the market to resume it’s uptrend, probably won’t participate in the opportunities through fear, a belief that money can’t be made in the market, or both.

The ‘buy and hold’ strategy employed by many equity investors over recent years during the bull market has proved disastrous as the market has collapsed. They have been left holding stocks that have collapsed in price, as the underlying businesses have imploded. With no clearly defined exit strategy or portfolio exposure minimisation strategy, they have simply sat and watched as their capital has eroded in line with downward pressure on share prices. Many of these investors are down in excess of 50%. I know of one so called ‘buy and hold’ investor with a significant parcel of RIO shares in his portfolio. The price of RIO has collapsed from a high of just short of $160.00 per share in May of this year, to around $40.00 today – and, he still has them in his portfolio!

He has not only suffered a huge reduction in the value of his portfolio, but has foregone a huge profit on the ‘trade’ through not having a clearly defined exit strategy in place. A compounding investment error is having too much of his portfolio in a single stock; we call this a money management error. In addition, the opportunity cost of not having banked the profit or limited the loss is enormous. Just think of what he could do with all the lost profit from that trade when the market once again presents us with buy signals! Instead, he is locked into a dud position with his fingers crossed while he waits for the market to return to the levels we saw in late 2007/early 2008.

Needless to say, he was NOT a SPA3 user. If he had been, he would have had clear and unambiguous sell signals provided by the SPA3 system, and would have been able to exit the trade, bank the profit or limit losses, and participate in new buy signals as and when they present themselves, starting again from a far higher capital base.

This is just a single stock without leverage through, say, a margin lending facility! Bring leverage into the equation across a number of stocks and the picture is far worse.

The majority of people in these and similar positions have little or no plan for engaging the market. Their buying decisions are loosely based on fundamental analysis, news stories, broker ‘advice’, newsletters, or hot tips from a mate, and do OK during a rampaging bull market, such as the one we experienced up until the end of 2007. But when the bull market ends and the bears gain control, these “punters” have no defined point at which to exit or lighten their positions.

Many also engage in another silly activity – that of averaging down! Instead of cutting their losses they fall for the age old trap of buying more because the price is now cheap. If the stock was a good deal at $10.00 per share, it must be an even better deal at $5.00, and then again at $2.00. They then watch as the market smashes their beloved share even further and they are left holding a worthless stock as a long term investment. The outcome of averaging down is increasing your exposure in a stock that is trending down! You should only do the exact opposite! Averaging down is predicated on the myth that all stocks will eventually go up again. Firstly, this is a total unknown amd mostly untrue and secondly, if they ever do, when?

Put simply, buy and hold strategies, don’t work over the long term. All it needs is a market reset such as has occurred with too much exposure to the wrong stocks or too much leverage - at the wrong time of your investing career - and your portfolio may never recover. Many have said it is “time in the market”. I have always disagreed. It is “time in the market” and “timing the market”.

The monthly log chart of the S&P500 shows a 20 year bull market followed by a 17 year sideways market then followed by a 17 year bull market. The S&P500 has been moving sideways now for nearly 9 years. Both sideways markets have had 50% or near 50% bear markets and 60%+ bull markets during the long term secular sideways movement. It may be many years before equity market indices make new highs that lend themselves to the buy and hold strategy again, as buy and hold strategies ONLY work in secular bull markets such as those from the mid 1940’s to the mid 1960’s and the late 1982 to early 2000 bull market. Active investment strategies will work in both long term secular bull markets and long term secular bear markets that mostly go sideways over many years. Why take the chance with a buy and hold strategy? Can your portfolio afford to move sideways with the market for many years to come if the sideways market continues for another 8 – 10 years?

Actively managed portfolio’s with a clear strategy for undertaking ALL buy and sell decisions that has an edge will always outperform the overall market and the buy and hold investor provided that the actively managed portfolio is sufficiently capitalised. SPA3 has proven this. The SPA3 strategy with hedging has managed to achieve 22.6% compounded per annum (or 402% total profit after brokerage pre tax) since January 2001 to current whilst the ALL-ORDS has managed just 1% compounded per annum (or 7.6% total profit), that is, sideways movement for nearly 8 years.

Mechanical traders and investors know that their system has a clearly defined and measurably EDGE in the market, combined with a strict set of trading rules and processes for engaging the market with confidence and consistency. They also employ strict money management and risk management that they adhere to at all times. In essence they know what to do, when to do it, and how much of it to do. They have minimal emotional involvement with their trades (unlike our friend above with the RIO shares) - they have developed a portfolio mindset (as we discussed in an earlier blog ), make minimal trading errors and they have developed the ability to execute all trades with a Traders Mindset (as discussed in last week’s blog).

I mentioned brokerage above. Active investment strategies in equities were impossible to to deploy up until the mid 1990's because the minimum borkerage rates were too high to actively trade. Stock prices, on average, did and do not move enough over a 2 - 4 month period to cover 2.5% each way brokerage rates. With minimum brokerage rates below $20 or 0.11% the era of actively managing portfolios was born. Couple this with the availability of investing tools and the 52% retracement of equity markets in 2008 the buy and hold investment strategy may go the way of the dinosaurs.

What will the market do in 2009? Who knows! The most important question is – “Will you be ready to participate when it does turn and the next uptrend begins?” Will you be prepared and confident and not only know what to do but to do what you know? Or will you still knee-jerk react by randomly selecting stocks based on news stories, fundamental analysis, brokers advice, newsletters, or some unresearched set of technical indicators? The key to success is to learn from the mistakes of the past, educate yourself, be prepared, and know exactly what to do next time. Employ a proven, mechanical trading strategy, like SPA3, and begin trading and investing in a professional manner using a proven strategy and processes with a clearly defined and measurable edge in the market. Doing the same thing that you have always done will result in the same outcomes.

My wish for 2009 is for all the buy and hold and leveraged investors out there to learn from their mistakes, shift their investing paradigm, re-educate themselves and employ a proven trading system with well defined risk management processes for all their trading and investing. This way the market can throw whatever it likes at you and you will be prepared.

I wish everyone a Merry Christmas and a safe, happy and prosperous 2009.

The many comments and questions our company has received over the past few months as equity markets have been massively sold off and some portfolios have suffered significant drawdowns leads me to this weeks topic on trading and investing from the markets perspective, that is, becoming empathetic with the market. I have discussed aspects of the importance of developing a Portfolio Mindset in an earlier blog. This week’s topic has a deeper look at developing the mindset and mental attributes of a skilled trader. This centres around your edge as a trader, understanding and accepting it, to allow you to trade and invest objectively and confidently over the long term.

From an early age in our life we are taught to think that losing is bad. We live in a competitive society where we are conditioned in our business, sporting and social environments to think that we must win at each and every task. This ‘competing to win’ mindset becomes ‘hard-coded’ into our thoughts and resonates through all facets of life. It has a profound influence on us each day, both consciously and subconsciously.

We are conditioned throughout our lives by our parents, peers, media and other environmental and social stimuli to feel negative emotions such as anger, embarrassment, disappointment and frustration when we lose or we are wrong. When we lose we think we have failed. We worry what others will think and how society will view us because of the loss. We know also, that winners are praised for their accomplishments.

In share trading, negative reactions to losses are no different. The same pressures, beliefs, expectations and disappointments are evident. Unskilled traders see losses and drawdown as failures. Resultant inconsistent trading often leads to complete withdrawal or avoiding executing for fear of more disappointments, not to mention poor results.

People in this position are dramatically different to a skilled trader who looks at the market objectively and consistently. Both have experienced the same conditioning from their environment - skilled traders have learned to think, feel, see and act differently.

To become consistently successful in the share market, skilled traders have learned to think in terms of overall probabilities - not in terms of winning and losing on individual trades. The relevance of the outcome of individual trades is minimal. They focus on the long term performance of the probabilistic edge of their trading method. Winning, losing, new portfolio equity highs and portfolio drawdown are seen by the skilled trader as the probabilities playing themselves out in the market. These are normal occurrences for the skilled trader. They actually expect them to happen and have conditioned themselves to accept that they will happen in the natural course of their trading and investing business knowing that the variables and combinations of variables that interplay in the market are near limitless.

So what do we mean by probabilities and where do these probabilities come from? We mean that you must understand what your probabilities of success/failure are from the way that you trade the market. These probabilities are determined by the number of times that you win and how much you win compared to how much you lose, on average, over a large sample.

When this is measured through research over a large sample of trading events, through different types of markets, you can determine the mathematical expectation for the way that you trade. If you cannot understand or define your probability of success then you are gambling and should not commence trading until you do understand your probabilities of success. All of Share Wealth Systems' solutions have been designed from this perspective.

Many novice traders draw rash, subjective and impulsive conclusions from small samples and brief experience. Immediate success is craved for confidence building and self determination. This is another trait learned from modern society, that of instant gratification rather than delayed gratification. It is normal to want to win as many times as possible, especially early in a new trading enterprise. The confidence gained from success leads to an expectation of future success. However, sophisticated traders define their edge precisely, know the probability of success that it represents, know the term over which it delivers success and know an adequate sample size is required for long-term results.

To make the transition from a novice trader’s perspective to that of a skilled trader who thinks from the market’s perspective, often means changing ingrained beliefs and ‘reprogramming’ our mindset to a new understanding. Share Wealth Systems’ training services and solutions are designed to help you become a skilled trader.

Becoming empathetic with the market means that you will no longer think in terms of “right” or “wrong” or “win” or “loss” on individual trades. Taking new trades and closing trades based on your trading system simply means you accept the probabilities of your edge. Whatever the result of individual trades, you can be at peace knowing that the overall outcome will reflect the statistical probability of the system over a large sample of trades.

Being empathetic with the market means that you expect to have winners, losers, new portfolio equity highs and portfolio drawdown, that’s the innate personality of the market, that’s how it is wired, that is what successful traders are empathetic of.

Most traders do not understand, or fully accept, this concept. Many dismiss it as unimportant but most of these traders are destined to failure. I suggest that being empathetic with the market is an absolutely essential component in the make-up of every successful trader.

Take time to seriously consider how you think and feel about each trade you execute. Critically analyse your feelings and actions to determine what you need to do to better align your thinking with the market’s movements – probability, as opposed to over emphasising the results of each and every trade and becoming overly involved emotionally with these trades. Know and really understand your system and trading edge so that you expect, accept and embrace the outcomes. It is the long term performance that is far more important that the result of each winning and losing trade.

If you don’t have an EDGE yourself, you should seriously consider SPA3 as your trading system. Not only does SPA3 provide investors with an EDGE, it provides the rigour, process and structure for long term success in the market.

To take advantage of SPA3’s 10th Anniversary special offer, click the link below.

Last week I discussed SPA3 risk profiles and the differing effects that each have on overall portfolio performance. This week I’d like to discuss the benefits of using a hedging strategy to offset potential losses from a long only, medium term equity trading strategy such as SPA3.

When I set about designing and developing the SPA3 system which was first released to our customers in August 1998, my #1 criterion was to develop a strategy that would provide the user with an EDGE under all market conditions. This has not changed and although SPA3 has been improved over time the principles and signals of the strategy remain the same bar the addition of one signal in 2004.

From 1998 until November 2008, SPA3 has only been an investment strategy for buying stocks. It has contained no short selling strategy. With a 53% retracement in the market index and drawdown in the SPA3 public portfolio hitting as high as 32.51% it has justified the devising of a low correlated shorting strategy that would be executed during SPA3 high market risk periods. Furthermore, to trade through such a phase in the market and not make a change to a trading methodology that can improve its execution and performance in the future, would be irresponsible and naïve for a systems research company. My aim was to introduce a hedging strategy where SPA3 users would short sell an ASX200 CFD when a SPA3 high market risk signal occurs. The hedge would be put in place to reduce drawdown in a falling market.

It must be said that eliminating drawdown so that the portfolio makes money under all market conditions is extremely challenging. My aim was to have portfolios tread water in a falling market and then maximise the returns that can be made through medium term trading equities when the market starts to move in an upward trend again.

I have placed the two equity curves of the two strategies below. Figure 1 shows the unhedged long only SPA3 public portfolio from January 2001 to present. It has traded through September 11 2001, the 2002-2003 bear market where a 20% retracement occured in the index, and the recent bear market.

FIGURE 1. SPA3 Long only – no hedging strategy

When looking at the performance of any portfolio it is important that you firstly have a large sample of trades in differing market conditions. This portfolio has just that. The blue line is a marked-to-market equity curve of the portfolio and the black line is the All Ords index. You will notice that the out-performance over 7 years and 10 months is $226,980 starting with a $100,000 portfolio.

Typically, SPA3 portfolio’s have achieved half to two thirds of the drawdown of that of the All Ords in a falling market and have achieved around double the rise in a rising market, depending on portfolio size. You will also notice the portfolio’s equity curve is similar in shape to the All Ords as this portfolio trades stocks long only.

I know that a 53% retractment in the index affects SPA3 portfolios negatively even though they have out-performed the index. However, performance could be improved by further reducing drawdown.

Figure 2 shows the results of the SPA3 public portfolio including the SPA3 hEdge strategy. It has been run over the same period with the exact same long positions in place. The only difference is that the SPA3 hEdge trades have been added to the portfolio. Comparing the two equity curves in Figure 2 you will now notice that when the market falls and rises sharply the hedging strategy kicks into play causing the portfolio equity curve to inversely mirror the All Ords index.

FIGURE 2. SPA3 with hedging strategy

There maybe times in a bull market when the hedging strategy will give money back to the market because of small ‘false’ high risk markets happening along the way. This is a lot more manageable, as investors struggle considerably more with drawdown than not making as much on the way up.

From the SPA3 equity curve performance in Figure 2 it is clear that the results of employing the hedging strategy far outweigh not using it. By simply short selling index CFDs when a high market risk signal occurs, we have actually been able to eliminate drawdown during this bear market whilst at the same time remaining committed to our long only equity portfolio although at greatly reduced exposure.

Figure 3 lists the hedge trades over the life of the portfolio. Please make note that in 7 years and 10 months the portfolio has been hedged a total of 36 times. There have been 22 loss trades totaling $84,057 and 14 winning trades totaling $240,528, this makes the winning trades 2.861 larger than the losing trades. This is an edge. The hedge position sizing is calculated mechanically using the SPA3 portfolio manager.

FIGURE 3. SPA3 HEDGE TRADES

What the charts are unable to show are the psychological benefits of employing a hedging strategy. The charts can’t show the sleepless nights and periods of intense worry and stress experienced by those traders hanging onto “quality” stocks during these rough times and watching their portfolios lose value day after day as the market fell sharply from its dizzy heights.

For long term investors with a long only view of the market, and for those unable or unwilling to use short selling of equities or derivatives in their trading, the use of a hedging strategy adds security to your portfolio. It ensures that portfolios can be maintained, dividends still received, and long trades still entered, even though the market is falling, as the value of the portfolio can be offset by hedging. You will still need market generated trigger or signal as to when to and when not to hedge. This is imperative as in a rising market you will give it back plus more if the hedge is left in place. In a fast falling market, such as the one we have recently experienced, it can also actually result in hedging profits being generated – a nice bonus!