How to Follow a Trading System

Follow A System Rather Than Emotions

Investor's Business Daily -

Jesse Livermore, a famous old trader, who made and lost millions in the stock market, once said: “There are only two emotions in the market — hope and fear. The problem is, you hope when you should fear, and you fear when you should hope.” In this lesson, Bill O’Neil provides insights on how to keep emotions out of investment decisions.

Q: What did Livermore mean by “hoping” when you should “fear” and vice versa?

O’Neil: When a stock falls 8% below your cost and you’re losing money, you hope it’ll go back up. But you really should be fearing that you might lose more money. And you should react by selling the stock and cutting the loss.

When a stock goes up in price and you’re making money, you fear you might lose your profit. So you sell too soon. But the fact that the stock is going up is actually a sign of strength and an indication that you may be right.

Q: Isn’t that against human nature?

O’Neil: Whenever your own money is on the line, it’s going to be emotional, and the stock market is no exception. But the market doesn’t know who you are. And frankly, it doesn’t care what you think or what you would like to see happen.

Human nature is deeply embedded in the market, and the same emotions of ego, gullibility, fear and greed that existed yesterday continue today.

Q: How do you overcome these natural, yet potentially costly, emotional reactions?

O’Neil: In my experience, the only way is to establish buying and selling rules derived from historical research — rules based on how the market actually works, not on personal opinions and preconceived ideas.

Lawyers analyze history and use precedents, so why shouldn’t you? The more you know about the past, the more you’ll be able to recognize future opportunities.

Q: How is the past helpful in the case of the stock market?

O’Neil: We’ve built models, or profiles, of every outstanding stock each year beginning in 1953. Rather than listening to supposed experts, personal opinions, hot tips and rumors — many of which are faulty — I know exactly what the characteristics of the biggest winners of the past were. It’s a recipe for successful stocks that can guide me as I seek tomorrow’s new leaders.

Analyzing history also provides perspective on the market as a whole. Daily and weekly market fluctuations intimidate even the most experienced investors. But a look at the past will show that there’s an overall uptrend in the market, cycle after cycle, that creates a huge ongoing opportunity for investors.

Q: So knowing the facts and examining history are the keys?

O’Neil: They’re important. But so are developing sound habits and sticking to the rules. And that’s the harder part. It can be even more difficult for individuals who have followed unhealthy investing habits for years and years. Changing these frailties is a real challenge and takes considerable effort.

Q: What are some of the worst habits investors have?

O’Neil: One is an overwhelming attraction to low-priced stocks. The idea of buying a large block of a $2, $5 or $10 stock and watching it double sounds wonderful. The only problem: Your odds of winning the lottery may be better.

The fact is investing in stocks is not the same thing as buying a dress or a car on sale. The market is an auction marketplace: Stocks sell for what they’re worth at the time. And when you buy cheap stocks, you get what you pay for.

Of the best-performing stocks of the last 45 years, the average per-share price before they went on to double or triple or more was $28 a share. This is a historical fact. Cheap stocks involve far greater risk.

Q: So should that be the minimum?

O’Neil: I do not buy stocks under $15 a share. Of my really huge winners over the years, I bought them between $16 and $100 a share.

Sound scary? Don’t laugh: The $100 stock went to the equivalent of $550 a share. The outstanding companies that are leaders in their fields just simply do not come off the launching pad at $5 or $10. There are very few, if any, exceptions to this rule.

Many people want to get rich overnight, which just does not happen. Success takes time and a willingness to objectively and honestly analyze your mistakes. That’s the key to getting smarter at anything in life.

Q: Admitting mistakes isn’t easy, is it?

O’Neil: No one likes to be wrong. But letting your ego get in the way of proper analysis of a prior action, or falling in love with a stock and failing to look at it objectively, are simply not sound when it comes to the market.

An invaluable tool I’ve found is to do a post-analysis of all my trades. Every year, I jot down the point on a daily chart where I bought and sold every stock, as well as the reasons I bought or sold each one.

Then I separate those I made money on from those where I lost money. What was I doing right on the stocks that went up? What mistakes did I make with the others?

I then make a few new rules that will prevent the same mistakes in the future. If you don’t look at what you’re doing wrong, you’ll never become a better investor.

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