Avoiding “System Drift”
Two Potential Leaders of the Next Advance
One of the most common shortcomings I see among investors is the inability to (a) pick a system that fits their investing personality, and (b) to stick to that system, even after a few less-than-stellar months. Both are actually closely related.
The first of those is pretty easy to understand—if the system an investor chooses to implement regularly results in, say, huge drawdowns from time to time, yet that investor has trouble keeping his wits about him after a bad day or two, he simply won’t be able to stick to that system over time. The same goes for the opposite case; if an investor seeks thrills, but buys only blue chip, dividend-paying stocks, you can bet that he’ll eventually start poking around growth stocks to satisfy his urge.
However, even if they’ve found a system that’s compatible, many investors still do not stick with the same system over time … and in my view, that is one of the main reasons so many investors fail in the long run.
The obvious question, then, is “Why do investors shift away from solid, well-constructed systems?” And I have the answer: Because they let the good be the enemy of the perfect. Let me explain.
Every system has strengths and weakness. One that buys leading growth stocks that are under strong accumulation (the system I use) is good at getting on big winners as they begin their price advances and riding the uptrend for weeks, months, even years if all works well. But it’s not as good in choppy environments, when most breakouts fail and stocks tend to gyrate up and down without much of a trend.
Conversely, a system that uses overbought and oversold indicators— consistently buying after a few bad days, and booking profits after a few up days—makes its best money during choppy environments. However, that system will tend to lag badly in trending markets, as overbought (or oversold) often becomes more overbought (or oversold) during a strong trend.
I could go on—day traders love when markets are highly volatile, giving them plenty of opportunity to gain. However, the downside is that making 10, 20, 30 or more trades each day can cause a lot of stress and opens the door for lots of mistakes; during a strong uptrend, you usually make much more by just sitting with the best leaders, instead of trading them all day.
And, of course, we can’t forget about value investing systems, which “allow” investors to buy near a stock’s lows in many cases, taking advantage of big selloffs in the market or in individual stocks. The downside, of course, is that sometimes those beaten-up stocks become even cheaper in the months after!
All of these systems work to one degree or another; all have been proven over time. However, as I just explained, all will lag in certain environments and do very well in others. And it’s that part that is difficult for most investors—they’ll see others doing well when they are lagging, and be tempted to switch boats in midstream.
The real danger in doing that is, eventually, the new system they switched to will also start to have a rough period … leading them to switch again. And again. And again! After a few years time, this investor will be a jack of all trades of sorts, doing some value investing, shorting, growth stock buying, swing or day trading, etc.
Yet this investor will also be the master of no one system … and in the market, the way you make big money is to know, understand, believe in and execute a successful system inside and out.
Bringing this discussion back to the current market environment, our system has done OK this year, but has been chopped around a good deal with the market’s various ups and downs. Because of that, I have been inundated with subscriber questions asking things like “Shouldn’t you sell XYZ stock and take your 10% profit?” “Shouldn’t you buy an inverse ETF to take advantage of the market’s downside?” and “Isn’t now the time to take advantage of some beaten-down leaders?”
My answer to these queries isn’t necessarily “No, definitely not!” as much as “It’s not within our system to book ultra-quick profits, or short the market, or to buy leaders 25% or more off their highs.” In other words, it’s not that any of these tactics are “bad,” but they’re not part of our system and I’m always wary of “system drift.”
For an analogy, consider a football team’s offense. They start out every year trying to be balanced—i.e., their system is to both run the ball and pass the ball with effectiveness. But then they see after a couple of games that their passing game is way above expectations, so they begin throwing the ball nearly every down. In the short term, they gain more yards and score more points as the passing game is generally more explosive than the run game.
However, in the long run, defenses begin to focus more on the quarterback, since they don’t have to respect the run game. The QB, then, gets dinged up, and begins to wonder how many big shots he’ll take each game. Moreover, the weather worsens as the season progresses; his accuracy declines and more balls are tipped or thrown off the mark, leading to more turnovers. And, of course, there will be more sacks (QB tackled before he can throw it) as the number of pass attempts rise.
Translation: The team would have been better off being patient with their offensive game plan rather than switching after a couple of so-so performances by the run game.
Again, this isn’t about which individual system is better than the rest—there are many ways to make money in the market (and that’s one reason we have 10 newsletters, which go about producing profits in different ways). It’s really about finding the system that fits you, and then learning all you can about it, and sticking with it for years and years. It’s something to consider during this choppy, challenging market environment.
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As I’ve been telling subscribers the past few weeks, there’s a split in the market these days—the major indexes are sagging and are near their 2010 lows, yet many individual stocks are still in grinding uptrends during the past few months. In fact, this past weekend I made it a point to closely examine the weekly charts of the major indexes and many stocks (each chart has three to four years of history).
What I saw surprised me: Many stocks are building long, multi-month launching pads, despite the weak indexes. In fact, more than a few formed sound launching pads, broke out in July, and are now forming other bases on top of the prior consolidations—that’s known as a “base on top of a base” and is usually a bullish pattern.
I’ve also seen a few choice stocks actually pushing consistently higher in recent months in a volatile way. Of course, it will all depend on the market’s next big move, but this pattern of gradually higher highs during the four-and-a-half-month market pullback tells me these stocks want to move higher.
Two that have similar patterns are Netflix (NFLX) and Akamai (AKAM), two big-cap stocks that I feel have the potential to help lead any coming market advance. I won’t delve into the nitty-gritty of the fundamentals. Suffice it to say that NFLX is positioned as the leader in on-demand video, while AKAM has the largest content-delivery network in the world, and is poised to benefit as video and data traffic continue to soar … partly thanks to on-demand video offerings from the likes of Netflix!
What intrigues me is that both of these leaders have very similar chart patterns—they each corrected sharply at the end of June, and then bounced for a couple of weeks in July … but failed to reach new-high ground. And then each fell sharply again—to lower lows—after disappointing reactions to their earnings reports near the end of July.
That lower low caused a shakeout and formed what is known as a double bottom pattern. But for the pattern to be complete, the stocks would have to race to new highs soon after that second low. And they did! Both moved up in a big way as institutions piled in.
Now NFLX and AKAM have pulled back toward the top of their prior double bottom patterns, hovering above their respective 50-day moving averages. If you’re aggressive, I think you could buy a little (maybe a third or half of your normal-sized position) of one or both here … as long as you keep a tight, 5% to 7% protective loss limit on each position.
If the market can find a low around here and begin a sustainable advance—and I think there’s a decent chance of that—then both NFLX and AKAM have a shot at big gains.
Click here to learn more about Netflix, Akamai and other leading stocks featured in Cabot Top Ten Weekly.
All the best,
For Cabot Wealth Advisory