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Sunday, January 14, 2007

Principles of Share Trading as aligned with Fundamental Analysis

The author of ASXNewbie has been posting an article by Charlie Wright on the Principles of share trading.

It has been posted in a three part series. Here are the links to Part1, Part2 and Part3.

I have taken a few comments from the article as they apply to investing with fundamental analysis as well as technical analysis.

Sound money management and risk control are the keys to being a profitable trader. I will say over and over again, it is not the prediction or the latest and greatest indicator that makes the profit in trading, it is how you apply sound trading discipline with superior cash management and risk control that makes the difference between success and failure

This is true of fundamental analysis as well. You need a sound technique for picking quality companies and then you need to apply good cash management and risk minimisation to make the best possible opportunity for a profit.

Have a Healthy Time Horizon.One of the biggest problems new traders have is that they think they will make a large amount of money right away. They think they will get rich quick. This type of reasoning is very similar to the short-term thinking in American business in general, usually managing for the current quarter’s profits, focusing on short-term earnings at the expense of long-term investment and profit growth.

With fundamental analysis we are not in this for the short term 2%-4% profit. We are looking for the shares that are going to increase by 20%-100%. We are looking for quality companies that are undervalued by the market so that when they revert to the mean we can make a significant profit.

Give your trading strategy enough time to work.We tend to be impatient, and we sometimes think that we should get instant gratification. This will not work in trading. The only way you will really know whether you are a successful trader
is to be successful over time. A week or a month will not be enough time to tell you how you are doing. You should be trading with the objective of making money in the long run, consistently, and with the confidence that your strategy will make money given enough time.

Fundamental analysis usually focuses on stocks which are out of favour and are undervalued. It may take time for the market to agree with your perception of the company. It usually will rely on an earnings upgrade or an important announcement before people start to take notice of the company. The only reason to get out of a trade is if you feel the company no longer has the qualities of a good company based on your previous assumptions.

Use historical statistics.I don’t think anyone has ever traded without first looking at historical statistics. Even some traders who deny they are strategy traders have used historical data....Before I would trade it, I absolutely insisted on knowing what the strategy’s personality was and how much money it would have made. Using historical statistics gives you great peace mind, particularly in learning to love losing trades. Knowing the history of a trading strategy can give you tremendous psychological comfort during those tough periods of losing trades and draw down. Historical statistics tell you how much money the strategy has lost in the past, how many losing trades it has had in a row, and the largest losing trade the strategy has experienced. This is very important information if you are learning to accept losing trades. Comparing historical data with the current string of losses and draw down can give you much comfort that what you are experiencing now is not unusual and has happened before. Maybe not in exactly the same manner, but it has happened before.

There are many books which have investigated the use of fundamental analysis techniques over a long time frame ( 25 years +). In all cases it has found the low Price to Earnings, Low Price to Cash flow, Low Price to Earnings Growth and Low Price to Book Ratios have been successful techniques for making above market returns. Knowing this allows us to follow these techniques which the knowledge that we should make a profit longer term.

I have met many successful people, and the one thing that they have in common is that they love what they do. Many have told me they can’t believe that they actually get paid for doing what they do. They have so much fun they feel guilty taking money for doing it. Many successful people will tell you that they would do what they do even if they weren’t paid at all.Successful people don’t work for the money. Work hard and love what you are doing and the money will follow. Successful people work first and count the money later. Sometimes they don’t ever count it, and some don’t even know (or care) how much they have. They just know that they have enough to allow them to continue what they are doing; working hard and having fun. Love trading for its own sake.

This is very true for myself and I believe is a reason why I am successful at selecting shares. I spend hours reading through annual reports and analysing the industry, comparing companies and researching competitors that I get a good feel for the shares that I own. I love feeling that I have put in some hard work and come out with a great result. Even when the market does not agree with my analysis I am eager to await the pending announcements so that my analysis can be confirmed or rebuffed. It is the love of the work that makes you a successful investor.

In the final analysis, any market is just a collection of individuals making decisions and placing money in the market based on these decisions. Most of these individuals are doing what comes naturally to humans, buying low and selling high. Statistics show that 95% of these people lose money. To be a successful trader, you have to do the opposite of what this 95% is doing.

I believe that 95% of people in the market are trading. Only a few select people are taking the time to analyse companies and buy profitable long term gold mines. It is the extra analysis that occurs that is not being done by the 95% of people in the market. Even the managed funds have extremely high turnover these days. Remember commissions hurt and a long term position has a lot less commissions then entering, exiting, reentering, re-exiting .... etc strategy. Losing 2% a year in commissions can cost as much as 22% of your portfolio after 10 years. This is a significant amount.

While this article was aimed at traders I feel anyone who is in the market can gain some insightful knowledge on how to use money management and risk control for investing. It will be very worthwhile that you go and read the entire series so that you can improve your own investing.

Good Luck Investing.

2 comments:

strudy1 said...

1Greetings. A great site. I was wondering would you be interested in a permanent links between us?
Obviously we have the same goals in mind.
Let me know your thoughts on this.
You can contact me via ASXNEWBIE.
Kind regards Chris.

Paul Smith said...

Chris,

Ive added your link to my site. I have been meaning to do that for a few days now.

You also have a great site and I am a regular reader.

Thanks
Paul.