Didn't he write that during a Bull market? It might make a difference. Maybe that's why they say that past performance is no guarantee of future performance.
It may have been written during a bull market, but the observations spanned both bear and bull markets
<b>Emotions are Short-lived</b> Although emotions certainly do drive the market, they tend to operate on a short-term basis. Fear cannot last forever, eventually the price of the tradeable is driven to an excessively low level and bargain hunters (like bignatty and myself) step in and buy. This halts the downward momentum and stops validating the fears. Once the fears cease to be validated (and the bottom feeders start seeing profits), then the price starts climbing back up. This leads to hope which can build to irrational exuberance (and we all know how that ends up). Admittedly, these cycles of fear and greed are seldom so clean cut (but then neither is the trend universally friendly). But the point remains -- long-term traders can find profits by betting against an overly emotional herd. And don't forget that the "smart money" can be quite unprofitable at times because their definition of risk and reward is not just financial -- a fund manager that makes the same mistake as the herd does not get fired. <b>Its not hope</b> Just as the short-term trader acts on the repetition of patterns in the market, so, too, does the long-term trader. If long-term trader "hopes" for a reversion to fair value, then short term traders "hopes" for a continuation of the trend. Neither style of trader is guaranteed that their setup will lead to profits. Whether one is trying to justify a belief in a future price or justify a belief in a trend continuation, one could argue that both justifications are on equally strong (and equally shaky) ground. <b>Risk Management</b> Where most of the short-term traders here manage risk by limiting losses on each trade, the long-term position trader faces the potential for unavoidable losses in the overnight price gap. Thus, the need to diversify in a larger number of smaller positions. If you recognize that there is a chance of error in fundamental analysis (or the potential for a massive change in fundamentals), then you can avoid the "value trap" with strict upper limits on position size. Your suggestion of 20-30 positions is a good one, although I've heard that the latest in portfolio research has raised the minimum to over 50 (due to the winner-take-all effect). Short-term traders think that their risks are lower, when they are not. The funny thing is that the average short-term trader sees a 1-2% loss on 30%-70% of all trades every day. In contrast, the long-term trader sees the scary oft-touted 33% to 50% overnight loss on 1/30 of their account only very rarely. Its not unlike the people that are afraid to fly, but are comfortable driving a car. One of the major cognitive errors made by people is in overweighting extremely rare, large magnitude risks -- especially when they believe (rightly or wrongly) that they lack control over the situation. <b>Caution 1: When low price causes low future earnings</b> I am sure that bignatty is aware of this, but one issue with trading undervalued stocks is the self-amplifying nature of the bear -- a company's future earnings stream may be jeopardized by overly pessimist market emotions. Companies that need to raise additional cash to fund operations, R&D, or strategic initiatives may find themselves cutoff by the erroneous emotional opinions of the financial world. Even if the company does not desperately need additional capital, it may find that it has fewer strategic options than its competitors -- putting the company at a long-term disadvantage. A crisis of confidence can kill or weaken a company that is not financially self-sufficient (strongly cashflow-positive). <b>Caution 2: Market Risk</b> One issue that long-term traders need be wary of is market risk -- that the entire market enters a slump in which the definition of a fairly-valued P/E level drops. If too many investors think the overall market is too risky, the "fair value" of all stocks will drop. This is what makes arguments about "historical P/E" levels so dangerous. The question is, when will all the baby boomer's trust their retirement money return to the market again. The extent that investors turn away from the market will have a long-term depressive effect on P/Es. <b>Hedging Risks</b> You can hedge risks in a couple of different ways. You could use put options (e.g., the long-term LEAPs) to hedge against risk, but I would be wary of this strategy. The key is to determine if the LEAPs are overpriced (because of erroneous bearishness and the volatility attendant with falling stock prices) as much as the stock is underpriced. Another way to hedge risk is to short an appropriate index. This makes the assumption that your portfolio of undervalued stocks will outperform the market (whether the market is going up or down). Shorting the market is not risk-free -- if your portfolio of undervalued stocks all go down while the market is rising, you will see large losses. Good luck, and good long-term trading to you, Traden4Alpha
it doesn't quite work that way. It's not just risking only 2%. Pick what ever number you want, but if you pick 2% per trade, that means you also need to risk 2% per trade. if the only way you are going to lose 2% on a particular stock is for it to go broke, your risk is going to be way too low to show any kind of meaningful return. So, with $100,000 and you want to risk $2000 per trade, you would have to have (in a cash account) a lot fewer than 50 stocks. And then presumably give up on the trade at some point before the stock goes to zero. Otherwise your risk is too small. With equal amounts in all stocks, you could have 25 stocks and give up when you have lost 50% on a single stock. That's a start. Or ten stocks of 10,000 each and you risk a 20% loss on each stock, but only 2% of total equity. It really doesn't matter how you split them up, but each failed idea should cost you your chosen risk. Or in this case 2%.
BTW - unless the book was written prior to 1932 it was written during a Bull market. But it is now clear that you were not seeking advice, but affirmation. Look, I wish you no ill, nor do I care if you win or lose. But there is a touch of wishfullness in your methods - as pointed out earlier. You can not effectively manage risk if you look at the market as you do. You have this elaborate plan for getting in, but have no plan what-so-ever! You are trading on hope - the hope that your investment will increase in value, and the hope that you really are smarter than the market. Good luck - you will need it.
He didn't ask if buying low p/e stocks was a good idea, he asked about how traders manage risk. Low p/e stocks is not my cup of tea, but the risk management is the same for all of us.
How does one distinguish between the traders that are trading on hope from those that are trading on something more than hope? It seems like there are daytraders that are trading on hope too -- hope that the emotional tone and trend of the market won't reverse after entering an order. Why can't one say that ALL traders "hope" their position improves in value? And, how do either short-term or long-term traders make the transition from hopeful rube to confident profit-maker? It seems to me that bignatty's hypotheses about long-term market behavior are as testable (and tradable) as those put forward by short-term traders. Whether bignatty has tested these hypotheses (and whether many of the short-term traders in ET have likewise tested their hypotheses) is another matter. Wondering if the difference between hope and confidence is not the difference between ignorance and delusion. Traden4Alpha P.S. Tampa is totally right about post-1932 = bull market. Too many analyses of market behavior limit themselves to this country's recent history of rising economic performance.
I think there is some confusion about what risk management is. In order to have risk management you have to have an exit strategy.
you may want to check out his screener http://moneycentral.msn.com/investor/finder/deluxestockscreen.aspx?query=O'Shaughnessy+Growth+Stocks there was performance table somewhere as I recall it wasn't that impressive
"I believe James O'shugnessy wrote a book along theses lines and the results were quite impressive." last report i saw he was creamed during the bear. you plan to buy beaten down stocks can work but you have to watch out for debt.when companys cant service their debt they are doomed and wont come back.you also need to be able to take pain because it can take a long time for the market to see what you think you see.