Ask Colin

Do you have some kind of corrective measure if your analysis of the current phase of the market turns out to be wrong or premature?

The detailed question was:

I’ve very much enjoyed studying your trading plan as outlined in Building Wealth in the Stock Market. You are very careful to put in protective stops as insurance against a market trend change. Do you have some kind of corrective measure if your analysis of the current phase of the market turns out to be wrong or premature? For example, if you’ve reduced your shareholdings because of a mistaken belief that we are in the final phase of the current bull market, how do you identify the mistake and what steps do you take to rectify it?

This is a very perceptive question. It is in fact not an easy question to answer briefly, because there are a number of issues that are involved.

In your question you made a statement as preamble to your question:

‘You are very careful to put in protective stops as insurance against a market trend change.’

Let me address this first. It is a statement that I have encountered from many people recently as I have been speaking to groups around the country. Some of those questions have been rather more argumentative than yours. For example, when I teach how I manage market risk by varying my exposure to the market I am greeted with the proposition that surely I only need my sell stops to protect me.

I would not deny that sell stops are a key part of my investment plan. However, the sell stops apply to individual stocks. They are a measure to control specific risk, which is the risk inherent in each individual investment. Your preamble was about sell stops dealing with a market trend change. They do not do that, sell stops mainly deal with trend change in specific stocks. Only very indirectly do they approach the problem of trend change in the overall market.

I do not have a sell stop for the market as a whole. If you think about it, a sell stop on the whole market would not make much sense. I would be either in the market or out of it, with nothing in between. I would also be in the position of selling individual stocks because the market sell stop had been violated, even though the uptrend in that stock was still quite intact.

So, what I do is to separate these two things in my mind and in my plan. I manage market risk through the level of exposure to the market and I limit specific risk using money management, diversification and sell stops. I think it is very important to see these two distinct elements of my investment plan quite clearly and separately based on the primary risk element they are there to manage.

There is an important aspect to not relying on sell stops for management of market risk. Suppose that I had 16 positions, with an average risk to my stops of 1%. Then suppose we had a really sharp fall at the end of the bull market. 1987 was an exception, which if it was repeated would devastate the portfolio. Instead, just consider an ordinary sharp fall of about 10%, which triggered all the stops and with slippage cost me 20% of capital. It would then take a 25% gain on my remaining capital to recover the losses. This might easily mean I miss out on two years or more of potential gains.

This is why I think an investor has to have a strategy to manage market risk. A trader might use Dr Elder’s method of never risking more than 6% of total capital. Most good traders may rarely have all their capital in the market and no matter how much they have at risk, the 6% rule Dr Elder uses will manage that issue. However, an investor using a plan like mine will be quite aggressive in wanting to have 100% of capital in the market in the first two phases of a bull market when the risk is relatively low. When the market moves into the third phase, rampant speculation, I drop my exposure initially to 70% of capital and then as low as 30% if the market is very hot or comes off a strong peak (which could be the last peak in the bull market). This achieves something like Dr Elder’s approach in terms of how much of my capital might still be at risk at the end of the bull market. It is not the same exactly and will tend to be a bit more aggressive, but it is a similar outcome, using a different method.

Having discussed that very important issue, I will now address your main question.

The superficial answer is the same one John Maynard Keynes gave to an interviewer when asked what he would do if what he wrote in the General Theory of Employment Interest and Money turned out to be wrong. His reply was along the lines that if he was wrong, he changed his mind!

The problem with that answer is that it conceals as many aspects of the problem as it illuminates. This is because in economics and investing, there are many issues for which there are no absolute right and wrong answers. There are many ways to make money in the markets. Some work out better than others at a particular time and place. Consider value investing. It will work really well for long periods. However, there may be equally long periods when investing in growth stocks gives a better result. Nothing I just said proves anything is absolutely right or wrong.

Your question relates to market phase analysis. What you are asking is what I do if I am premature in my judgement of the phase we are in. I think that is what you really wish to examine. Let’s leave being right or wrong out of the discussion.

Phase analysis is carried out by looking at all the things that are happening in the market and the economy around us. There is no one single judgement to be made. The process is to take each of the markers of each phase (these are outlined in my book Building Wealth in the Stock Market). We make a judgement on each relevant aspect. Then we form an overall view of where we are on the balance of available evidence.

Take as an example the last phase of a bear market – distress selling. When I detect that we are in that phase I want to begin to move up to 20% of my capital into the market. I look for uptrending stocks and buy some of them. If I can’t find any uptrending stocks, I am indeed premature and wait till they appear. If they appear and I buy them and then their uptrend fails, my sell stops take me out of those stocks as usual.

Now consider the present market. As I explained in detail in my book Hot Stocks (no longer in print), I have formed the opinion that we are in the rampant speculation phase of the present bull market. This overall judgement rests on a range of factors, some of which are far more definite than others. It is therefore an overall balance. As time goes on, some of these factors will vary – for example the likelihood of inflation rising and resulting in further interest rate rises. So, I may be more certain about my judgement, or less sure about it as time passes. I don’t see this as a problem. My market exposure strategy calls for me to be between 70% and 30% invested. That is a wide range. So, I may think we have entered the rampant speculation phase, but that it is still early days. In that case I might sell down to 70% invested. Then if the market rises into a strong speculative peak, I might shift quite quickly towards 30% invested.

Now, comes the point I think you are asking about. Suppose that the market comes off that strong peak. Then it falls in a sharp correction. The move down to 30% will have been a good one. If it is the final peak I will have been very happy with that strategic decision. Now suppose instead that after the correction, the market starts rising again. I might now form the view that there is more to come of the rampant speculation phase and increase my exposure to any level between 30% and 70% as I think is appropriate and also assuming I find the opportunities within the rules of my investment plan.

What I am explaining here is that investment decisions are not on/off choices, but are judgements that can vary in their level of conviction from time to time. My strategy allows me enormous scope to vary my exposure depending on my current judgement.

There is one big risk in all of this and that is in the area of psychology. We humans are very adept at rationalising what we want to believe. We have a strong tendency to decide something and then assemble the evidence that backs that conclusion, while subconsciously ignoring the contrary evidence. I try to deal with this by breaking down the judgement into a series of factors and looking in each area at the pros and cons of the view I am reaching. I am far from perfect at this, but I do my best.

In conclusion, I would adapt Keynes’ answer to say that as my views change I modify my strategic response accordingly, within the parameters of my investment plan. Even so, in everything I am basically a sceptic and I try to challenge every strongly held belief using the techniques of contrary thinking. There is a good basic discussion of contrary thinking techniques in my book Think Like the Great Investors. This is in many ways the most important book I have written because it deals with the biases and errors all humans fall into in making investment decisions.