All-Time High Stocks: Confused Investors Lose Money

A key reason why so many investors and traders lose money is that they are confused. I suppose this isn't surprising -- the stock market is confusing, and there are many investing half-truths out there. Over the years I've scratched my head numerous times thinking about apparent paradoxes like these:

How is it possible that Trendfollowing and Mean Reversion are both successful trading strategies?
How is it possible that traders like Brian Shannon make money without holding overnight while investors like Buffet are successful by holding for years, or even forever?
How can traders make money while other people claim the market is efficient?
Which is right: technical or fundamental analysis?

Nicolas Darvas grappled with questions like this as he transitioned from "Gambler" to "Fundamentalist" to "Technician" and eventually succeeded as what he called a "Techno-Fundamentalist". What I learned from Darvas is that he succeeded when he was able to do two things: avoid bad ideas and transcend false dichotomies.

Avoid bad ideas.
"Gambling" as Darvas referred to it, or "Playing the markets" as I've heard many people call it is simply a bad idea. It is a flawed approach and it will not result in lasting profits. Darvas had to get past this before he could even begin to develop his profitable trading style. The thing is, while he was in his "gambling" phase he didn't realize he was pursuing a bad idea and a flawed approach. As he says in the book:

"This was a strange, mad period, but it only seems so in retrospect. At that time I felt I was really beginning to be a big-time operator. I was proud of myself because I was working on tips of a more educated nature"

Transcend false dichotomies.
Eventually Darvas realized that gambling with his money by chasing hot stock tips was a bad idea and he became interested in studying company fundamentals instead. Surely fundamental analysis would be profitable because it is what the people on Wall Street do. Once again, though, Darvas spent a long time being confused. This time he was confused by the whirlwind of contrasting opinions and jargon, in his words: "I did not understand all of this, but I was very impressed by these erudite words and analytical comparisons." By the end of his fudamentalist phase Darvas had come to realize that studying the fundamentals was far from perfect and would not guarantee profits. In fact, one of the stocks he studied most carefully left him with a devastating loss:

"I had labored long and hard. I had done everything possible to avoid a mistake. I had researched, analyzed, compared. I had based my decision on the most trustworthy fundamental information. And yet, the only result was that I was wrecked"

Once he recovered from this blow, Darvas ignored fundamentals altogether and focused on price action. It was during this "Technician" phase that he developed his "box theory" which was a major breakthrough:

"I decided I would always do this: I would just jog along with an upward trend, trailing my stop-loss insurance behind me. As the trend continued, I would buy more. When the trend reversed? I would run like a thief."

During the ensuing bear market Darvas spent time thinking about what he had learned so far, and watching how stocks were behaving during the bear. At this point he noticed that the best performing stocks -- those that "gave ground grudgingly" -- were companies with improving earning power. This led Darvas to blend technicals and fundamentals in his ultimate strategy as a "techno-fundamentalist".

Today the idea of marrying technical analysis with fundamental analysis is not new. Investors Business Daily and others have made this approach readily accessible. What I want to focus on is how Darvas had the flexibility and imagination to blend two ideas that seemed to be at odds. Whereas so many people become set in their ways, resist change, and blame others, Darvas had the curiosity and determination to explore contrasting ideas and find a way to let them work together. Rather than engaging in a debate over "Technical" vs. "Fundamental" he transcended the dichotomy.

From Confusion to Clarity.
Coming back to my original point of confusion, my first priority as a trader is to have Mental Clarity. I firmly believe it should be among the top priorities of every trader or investor. Confusion is enemy number one -- it will bring down your profits and your spirits. In my view the apparent investing paradoxes are not issues to debate but issues to transcend by allowing ones self to think creatively and imaginatively (but not illogically).

For instance, consider trendfollowing vs. mean reversion. These strategies seem to be diametrically opposed -- one bets a breakout will continue, the other bets it will fail -- how can they both work? The answer is that one aims for large gains from a few winning trades, the other aims for small gains from many winning trades. They both operate on the same axes of probability vs. magnitude, they are just in different quadrants. Rather than debate which strategy is better, combining the two strategies has been shown to give a better equity curve than either one alone (see the paper MR Swing: a quantitative system for mean reversion and swing trading in market regimes by Abrams and Walker).

There are numerous ways to make money in the markets, many of which seem to be contradictory at first but they are not and may actually be complimentary. Transcending false paradoxes helps traders and investors alike gain a clearer understanding of how markets work and how their strategy works. This knowledge will enable them to move from a mindset of confusion and resistance to a mindset of clarity and flow.

The key thing, I think, is to avoid confusion and find a system that really fits with your personality, your account size, and your amount of free time. I am constantly striving to find this fit because life is always changing.

As I followed the crowd I also started to act like this. Instead of being a lone wolf, I became a confused, excited lamb milling around with others, waiting to be clipped. -- Nicolas Darvas

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