Three Steps to Better Decisions

Once an investor learns the technical analysis toolkit, the real question remains how to effectively implement a technically-oriented investment strategy.  As one of my mentors once said, “Analyzing the charts is the easy part. Actually doing what the charts say?  Now that’s the challenge.”

I often speak of the paradigm of The Mindless Investor vs. The Mindful Investor. The key to understanding the differences between the two is to focus on how they each relate to their past, present, and future as investors.

Source: Market Misbehavior

The Mindless Investor ignores the past, because it’s painful to relive difficult experiences.  They fear the future because it is unknown and unpredictable.  As a result of being unable to connect with their past and future, the present causes anxiety as well.

Source: Market Misbehavior

The Mindful Investor learns from the past, taking the time to reflect on past experiences both positive and negative.  They plan for the future, laying out a clear decision-making process so they are prepared for any outcomes.  Because they learn from their past and plan for their future, they are able to be aware of the present with a strong situational awareness of their surroundings.

While the paradigm of The Mindful Investor is meant to describe a way of living as an investor, it can also give you a good framework with which to approach particular investment decisions.

Let’s adapt The Mindful Investor’s toolkit to an investment decision, using what I call the Three Steps to Proper Decision Making: Prepare, Engage, and Review.  As we describe these three steps, I’d encourage you to think about your own process.  How well do you address each of these three areas, and where are opportunities to upgrade your own process?

1) Prepare

As a student pilot, I quickly learned that the most valuable work was often done before you ever got into the cockpit.  The preflight discussion, where you reviewed where you were headed and what potential dangers may emerge.  The weather briefing, where you studied weather patterns and wind speeds so you knew what to expect when you got to the appropriate altitude.  The preflight checklist, where you walked around the airplane to check all the mechanical components to ensure the plane was in working order.

You did all of this work ahead of time to minimize surprises during the actual flight.  You could never be 100% certain that things would work out in a particular way, but you were doing everything you could to prepare for the most likely outcomes.

Before I make a recommendation on a particular stock, or change a position in my portfolio, I use a technical checklist to identify whether or not the weight of the evidence supports my thesis.

Here’s the checklist that I have built up over my career, which I have used to teach investment professionals and college students how to minimize behavioral biases using the power of technical analysis.

→ Dow Theory
Is the price in an uptrend or downtrend?

→ Trend Lines
Where is price relative to trendlines drawn from key highs and lows?

→ Moving Averages
Where is the price relative to key long-term moving averages?  Are the moving averages sloping up or down? 

→ Pattern
Any clear price patterns recently?  What was the most recent signal?

→ Support/Resistance
Where is price relative to key support and resistance levels?

→ Confirmation
Can I confirm recent price moves using momentum indicators and/or volume?

→ Relative Strength
How would I describe this chart relative to other charts in my universe?

If you are a seasoned technical analyst, then nothing on my list should be a surprise. The process begins with Charles Dow’s definition of trend (are we seeing higher highs and higher lows, or lower highs and lower lows?) and concludes by comparing this chart to other charts, often using relative strength analysis.

The key to this checklist is using it consistently.  Even if your checklist is incomplete, it’s still pretty good if you use it regularly. To put another way, an imperfect but consistent process is way more effective than a perfect but inconsistent process!

I hope you have your own checklist that is written down somewhere. If not, I would write it on a piece of paper and tape it to your computer monitor immediately.  If you don’t have a checklist, you’re welcome to borrow mine as a starting point.  Just remember, the more you evolve this list and refine it over time, the more it will become part of you as an investor.

2) Engage

Now that we have prepared for the particular trade, ensuring that we have appropriately analyzed the opportunity, we get to the actual execution.  This is where we think about risk vs. reward, and understand what we hope to gain and what we’re willing to sacrifice for the opportunity to do so.

As a trend-follower, I tend to think much more about risk than reward.  If I hold a long position, and the price continues to appreciate, I’m inclined to ride the price as high it will go.  I learned mentality from working with institutional money managers, who would never want to sell a winning position.  A chart going up to the right would be called “long and strong” and you would never sell that until the uptrend had exhausted.

But defining a clear risk level is not an option for any investor.  At the point of entry, you should always have a clear “line in the sand” or “point of no return” where you agree that you will make a change to the position. 

Amateur investors will often ignore the risk side of the equation, waiting until the market moves against their position to determine whether or not they should sell.  Unfortunately, this opens you up to all sorts of frustrating behavioral biases such as endowment bias (“I can’t sell that stock because it’s one of my favorite positions!”) and confirmation bias (“I’ll just look for some evidence that backs up my current position.”).

The time to set your exit strategy is before you make the trade.  The phrase should be “I agree to buy N shares of stock XYZ and price X, and if the price goes to Y, I will sell.”  In your trading journal (which you should of course be using religiously) you should write something to that effect. 

One point to make here is that I’ve seen investors also rephrase from “I will sell” to “I will agree to review this position.”  I have no problem with that, as long as your process for reviewing the position is consistent and disciplined (see next section on Review).

I’ve often encouraged investors to treat their charts not as paintings but as notebooks.  Put a dashed red line directly on the chart, showing where you will exit a new position.  Save a note directly on the chart that explains why you entered the position and where you would agree to exit the position.

 

Source: StockCharts.com.  An example chart with an example note for illustrative purposes only.

All of these above tactics simply serve to force you to clearly define risk up front, and make sure you are most likely to comply with the rule if and when it’s triggered.

3) Review

Now that we have properly evaluated the potential investment, and we have clearly defined our risk and laid out a game plan for exiting the position, we now need a consistent process to review our positions to determine if changes are needed.

There are three common mistakes that I see people make with their review process.

First, they review their positions way too often.  Long-term investors, for the most part, do not need to review their positions multiple times every day, and usually not even multiple times every week.  If your investment horizon over a year, then I would be checking that portfolio once a week maximum, if not 1-2 times per month.

The reason for this is that even though your positions will fluctuate during the course of the week, you should be focusing on the long-term trends.  Long-term trends aren’t defined by day-to-day fluctuations, but by the course of time over many weeks and many months.

If you’re checking your positions all during the day, or worse yet if you have the positions updating real-time on your monitor, then unless you’re a short-term swing trader then you’re paying way too much attention to what I’d call the “flickering ticks” of intraday movements.  Make long-term decisions using long-term data.

The second problem I identify when coaching investors is that they are wide open to external influences.  Things like financial media, cocktail party conversation, and social media all have a place (potentially) in your process.  But they should come after you’ve conducted your own independent review of the data and decided on your own investment thesis.

One of the easiest ways to fall victim to confirmation bias (where you simply gather information that supports your preexisting thesis) is to hear a rumor or trade idea and then look for evidence to corroborate the thesis.  Your brain is programmed to assign greater weight to evidence that supports the idea, and minimize the importance of information that refutes the thesis.

Focus on your own process, strive to review your positions consistently and with discipline, and then you have earned the right to hang out on social media with all the rumors and hearsay.

The third common mistake I see with the review process is inconsistency.  As we mentioned above with the technical checklist, the key is to have a process and follow it every day/week/month. 

Set a time every week to review your charts and draw your conclusions.  For me, my process starts on Friday as I prepare the “Wrap the Week” segment for my closing bell show on StockCharts TV.  Then on Sunday I review all the S&P 500 member charts and make notes on key themes, patterns, and signals across the eleven sectors.

 

Source: my iPhone and my notebook, complete with quite illegible notes only I can most likely decipher

By sticking to this process every week, I’m able to better understand the underlying dynamics of the market, and better able to detect changes which I would argue are often reflected on individual price charts before the broad market averages.

The Mindful Investor fosters a healthy relationship with their past, present, and future.  By developing better processes to prepare yourself, engage the trade, and review your positions, you may find you are able to minimize the impact of emotions and improve your performance through greater market awareness.
 

David Keller, CMT
Chief Market Strategist
StockCharts.com

David Keller, CMT is Chief Market Strategist at StockCharts.com, where he helps investors minimize behavioral biases through technical analysis.  He is also President and Chief Strategist at Sierra Alpha Research LLC, a boutique research and consulting firm focused on managing risk through market awareness.  He is a Past President of the Chartered Market Technician (CMT) Association and currently serves on the CMT Curriculum and Test Committee.  David was formerly a Managing Director of Research at Fidelity Investments in Boston as well as a technical analysis specialist for Bloomberg in New York.  You can follow his thinking at MarketMisbehavior.com, where he explores the relationship between behavioral psychology and the financial markets.