Likewise, if you look at a chart of the Dow Jones Industrial Average from 1900 to 2001 (Figure 3), you see again that if your strategy was to buy and hold the Dow Jones stocks from 1900, your portfolio would show a net gain of about 6% per year. This, too, exhibits Winning Edge characteristics.

Here is a look at the NASDAQ composite from 1978 to 2001 (Figure 4). Again, a buy and hold strategy exhibits Winning Edge characteristics.

While a buy and hold strategy could have produced approximately 6 to 13% per year return in the previous examples, this strategy requires that you never sell while somehow replicating the index performance in your portfolio. Neither of those factors is very likely to occur in the real world, which calls into question the robustness of a buy and hold strategy.

It becomes apparent that some level of stock or mutual fund trading may be required in the real world if you are to attempt to increase the value of your stock portfolio over time. Let’s look at a few scenarios.

Figure 5a shows the portfolio value over time of a short-term stock trader who has occasional successes, but ends up giving back profits in subsequent trades with no net profit when all is said and done. This tends to be the experience of traders who trade without discipline and without rules – in other words, without a Winning Edge. Of course, such a trader could do even worse by consistently losing money over time as shown in Figure 5b.

Figure 1, on the other hand, shows the kind of results you would expect from a trader using a strategy with a Winning Edge.

Impact on Risk

There are many ways to define risk from highly technical statistics to very simplistic statements. I prefer to define risk in terms of what happens to my trading position that I don’t like. For example, I don’t like it when my portfolio suffers a drawdown (loses money), and I don’t like waiting to recover my losses so I can break even. Both of those occurrences represent risk to me and my portfolio. So it should not be surprising that my definition of risk includes both of those elements (Figure 6).

•  Percent drawdown: The amount lost from the previous peak portfolio value.

•  Time to break even: The opportunity cost of lost trading opportunities.

With this straightforward definition, it becomes easy to evaluate the level of risk inherent in various strategies.

Take a look at Figure 7, which shows the S&P500 from 1950 to 2001. What would be the level of risk for the buy and hold strategy discussed earlier? By simply examining the graph, you can see that the ‘time to break even’ took 7 years from 1973 to 1980, and during that period, the ‘percent drawdown’ was 48%. Since 1956, there were five other drawdown periods ranging from one and half to four years. While not as severe as 1973 to 1980, the ‘percent drawdown’ was still very significant, from a low of 16% to a high of 39%.

A key question you should ask is how long will it take the most recent bear market to break even? As of this writing, the ‘time to break even’ is two years and counting. The answer will only be known over time – it could be within the next year or could be as long as 7 years as was the case from 1973 to 1980.

Reviewing Figure 8 for the Dow Jones Industrial Average, from 1900 to 2001 the following risk assessment for a buy and hold strategy can be made:

As you can see from this data, ‘time to break even’ was extensive in the first half of the Twentieth Century.

Likewise, a review of Figure 9 for the NASDAQ index from 1978 to 2001 indicates the following risk levels for a buy and hold strategy:

While the buy and hold strategy technically has a Winning Edge, the preceding analysis shows that adhering to this strategy would have required uncommon resolve and patience to endure years, sometimes decades, of ‘time to break even’ and near-catastrophic ‘percent drawdowns’.

The stock trader who trades without a Winning Edge fairs even worse, as you can see from Figure 5a where the ‘time to break even’ and ‘percent drawdown’ are in a repetitive pattern that lead nowhere. Worse still is Figure 5b, where the ‘time to break even’ is infinite with ‘percent drawdowns’ approaching 100%.

Contrast that level of risk with a stock trader who trades with a Winning Edge methodology. As Figure 1 shows, ideally he experiences relatively short ‘time to break even’ periods with modest drawdowns. This trader is obviously the one to emulate!

Conclusions

The conclusion from reviewing this information suggests that in order to be successful, your strategy must indeed have a Winning Edge. Furthermore, your strategy must exhibit risk levels within your risk tolerance and be consistent with your goals, and why you are investing money.

Key Components

You should now have a good understanding of how a Winning Edge impacts returns and risk. It’s now time to dive deeper into how to potentially achieve a Winning Edge.

Remember, I defined a Winning Edge as an investment methodology that has the potential to produce net profits or positive returns over time. At least four key components are required:

1.  Money Management Guidelines

2.  Selection Criteria

3.  Specific Entry and Exit Rules

4.  High Velocity Turnover

The absence of any one of these components will dramatically reduce, or even eliminate, your chances of achieving a Winning Edge. Let’s now have a look at each of one these components in detail.

Money Management Guidelines

Money management is about balancing risk with reward. Given the risk inherent in any investment methodology, you need to have sufficient funds and personal resolve to cover that risk so you can continue to enjoy the rewards without being knocked out of the game.

The number one rule of money management and the most effective thing you can do is to reduce your methodology’s risk in the first place. For stock traders, you do this by only trading with the predominant trend. That is, you only take long positions in bull markets and only short positions in bear markets. The reason being is that three out of four stocks will follow the predominant trend.

The second rule is to ensure that the risk (drawdown percentage and ‘time to break even’) does not exceed:

• Your emotional tolerance for losses

• Your financial capability to live through those losses

• Your ability to stick to your trading methodology

Emotional Tolerance for Losses

For example, if your methodology is to buy and hold an index basket of stocks, then you must be comfortable with the multi-year ‘time to break even’ and drawdowns of 20% to 50% or higher that are inherent with this methodology. Otherwise, you may fall victim to selling at precisely the wrong time.

On the other hand, if your methodology produces minimal drawdowns and ‘time to break even’ as is potentially the case for the trader with a Winning Edge, it is much easier emotionally to stay committed to your plan.


Financial Capability

Financial capability is simply about assuring that given the funds you have available for trading purposes that you do not over-commit to any one transaction or position where an adverse outcome would impair or eliminate your ability to continue trading the methodology.*

Suppose your methodology has a Winning Edge which produces three out of four winners and an average gain and loss per trade of 8%. Suppose further that the maximum loss per trade is 30%, only happens infrequently, but it does happen. This is a great methodology, but only if you use sound money management rules. If you had the misfortune of investing all your funds in one stock trade that lost 30%, you would require an almost 43% gain in your portfolio value just to get back to break even.

A far better approach is to allocate your funds equally among five to ten positions where a 30% loser has only a 6% to 3% impact on your portfolio.


Sticking To Your Trading Methodology

Given a methodology with a Winning Edge, you can only succeed by sticking to the methodology. That means having the discipline to follow the rules and to keep trading even when losses occur, which they inevitably will with even the best methodology (remember, there is no Holy Grail in stock trading). It is much easier to adhere to this discipline if you have only committed funds to your trading program within your comfort zone (your Financial Capability).*

There are several methods that can be used to mitigate risk to accomplish rule number two of money management. Here are a few:

•  Diversify your money among non-correlated investments. For stock traders, diversify among several stocks.

•  Limit the percentage of portfolio funds committed to any one trade. For example, invest only 10% to 20% of your entire portfolio to one trade.

•  Estimate the expected maximum drawdown and ‘time to break even’ (based on historical data), and be prepared to cover such a drawdown in the future without abandoning your investment plan.

Selection Criteria

The second component to a Winning Edge system is to develop a set of criteria that must be met in order to consider taking a position in any given investment vehicle. For stock trading, this would be your criteria for selecting which stocks to consider for long or short positions. If the criteria are not met in any way, you should simply pass on that stock and go on to the next.

Stock selection criteria can typically be based on fundamental analysis (earnings performance, industry group strength, etc.), technical analysis (price patterns, support and resistance levels, etc.), or both. Whatever the basis, the criteria should be very demanding so that only the best trading opportunities emerge. For example, for every 2000 stocks, 100 could be selected by using fundamental criteria. Then, by applying technical analysis, orders for two stock trades could actually placed, expecting only one of those to following through with market action that triggers the order. The ratios look like this:

By using a very demanding set of criteria, you could potentially increase the odds of having a winning trade.

For fundamental criteria, I highly recommend Investors Business Daily’s fundamental data which is available for every stock traded on the major exchanges.

Remember, just because a stock meets demanding fundamental criteria doesn’t mean it’s a good stock to trade. Rather, you must be patient and wait for market conditions to align consistent with your trading system rules before pulling the trigger.

This is why high velocity and short-term trading can be such important components of a Winning Edge and why significantly higher rates of return can potentially be achieved compared to traditional buy and hold strategies. Figure 10 shows the power of high velocity trading.*

The Perils of Forecasting

It is important to note that forecasting market direction is not a key component of a Winning Edge. There are two reasons for this. First, it is impossible to accurately forecast market moves on a consistent basis. Second, thankfully, it is not necessary to be able to do so. But what do most people do? They listen to the forecasters for a clue on what strategy they should follow and how their investments will perform in the coming year. I believe this is potentially a losing strategy and inconsistent with a Winning Edge method.

This should be a great relief to all who have struggled with this issue. Instead, stick to the key components of the Winning Edge, and leave forecasting to the forecasters.

Summary

Let’s do a brief review of what was discussed. I talked about the importance of understanding why you invest money and what your goals are in that regard. I noted that there are several investment vehicles to choose from such as stocks, bonds, and real estate. Then, a powerful methodology called the Winning Edge was introduced. The performance of a buy and hold approach was looked at by analyzing the historical stock index charts in terms of rate of return and risk as defined by ‘time to break even’ and ‘percent drawdown’. And finally you saw how I believe the short-term stock trader with a Winning Edge had the potential to outperform the buy and hold strategy in both rate of return and assumed risk.*

I hope this report has been informative and adds to your success in the future.

Good trading,

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