Trading Rule – “Don’t let success change your trading strategy”

WHAT EXACTLY IS A TRADING STRATEGY? YOUR TRADING STRATEGY CONSISTS OF A SET OF TRADING APPROACHES AND YOUR TRADING DISCIPLINE THAT IS IN-BUILT INTO YOUR TRADING ACTIVITY. YOUR TRADING APPROACH DOES CHANGE FROM TIME TO TIME AND ADAPTS TO THE CHANGING MARKET CONDITIONS. THE TRADING DISCIPLINE, ON THE OTHER HAND, FORMS THE CORE OF YOUR TRADING ACTIVITY AND RELATES MORE TO YOUR PREMISES FOR TRADING. DISCIPLINE PERTAINING TO CAPITAL PROTECTION, STOP LOSS DISCIPLINE, DIVERSIFICATION ARE ALL THE CORE OF YOUR TRADING DISCIPLINE

HOW IMPORTANT IS BEING RIGHT IN THE MARKET?

Let us start off with a fairly difficult and delicate question. Let us assume that after due deliberation and analysis you have arrived at a total weight of 25% to rate sensitive stocks. Considering the uncertainty over interest rates, you have chosen to maintain this discipline. Over the last 2 quarters, rates have been benign and you realize that your rate sensitive portfolio has been sharply outperforming the rest of your portfolio. You logically arrive at the conclusion that if you increase the exposure to rate sensitive stocks then your overall portfolio returns will go up.  What exactly should you do? Should you shift a larger chunk of your portfolio into rate sensitive stocks or should you stick to your discipline of 25% exposure to rate sensitive stocks only? Remember, in the long term being disciplined is more important than being right. Let us understand why!

TRADING IS NOT JUST ABOUT RETURNS BUT ABOUT RISK TOO

One of the primary lessons you learn in the equity markets is that your primary focus should be on capital protection. If your capital is safe or you know your maximum loss then you always have another day to come back and fight it out in the market. Therefore, your investment strategy must be predicated on protecting your capital. By setting an upper limit of 25% for your rate sensitive exposure is intended to protect your capital in the event of a rise in interest rates. It does not matter how successful a certain part of your strategy has been. At any point in time, some strategies are going to be successful and some are not. What matters here is whether as a portfolio you are able to outperform the equity indices by a decent margin or not. When you let success define your strategy, there are two risks. Firstly, you are vulnerable to the risk of overexposure to a particular theme and that increases your concentration risk. Secondly, in the process of chasing your past success, you may be missing out on promising stocks off the future.

“By spreading your risk and maintain a clear investment strategy, you are more likely to be successful in long term investing” – Benjamin Graham

6 GENUINE RISKS OF CHASING YOUR SUCCESSFUL STRATEGIES…

  1. The successful strategies that you are tracking pertain to the past. As we have seen earlier, the past is not necessarily representative of the future. Just because a particular set of stocks have outperformed in the last 2 quarters, it does not mean that they will continue to outperform in the coming quarters too. This practice of extrapolating the past into the future is against the basic grain of investing and trading.
  2. Every strategy has a context and they tend to be successful because the context was favourable. Such contexts are caused by a set of circumstances and there is no guarantee that such a combination can sustain. Basing your entire investment or trading strategy on a fortuitous set of circumstances would be putting your capital at unnecessary risk based on something that is not scientifically proven.
  3. The whole idea of a portfolio is that you are provided with an inbuilt mechanism of being liquid when markets are down and being invested when markets are moving up. By shifting your portfolio to chase your historical success, you will end up losing out on both these advantages. That is something to be cautious about.
  4. Not all outperformance is due to fundamental factors. For example, we have seen sectors like banking and IT perform for a very long time just because there were institutional flows into these stocks. Here we are considering a time frame of just 2 quarters. Basing your future strategy based on the data from just 2 quarters may risk mistaking the noise for the trend.
  5. One of the basic assumptions of investing is that you diversify the risk of your portfolio. Over a period of time as portfolio concentration increases, you keep re-allocating to other sectors waiting for the big move. When you tamper with the original assumption of diversification you are actually changing the entire risk-return profile of the portfolio. That will also mean increasing your required rate of return. That is not factored!
  6. You are violating the cardinal rule of not averaging positions. You are applying the averaging rule in a reverse manner and the risk is that you could end up with an unfavorable price point. You lose your advantage. By averaging your position in the right strategy, you are falling victim to the popular fallacy that what was right will be right and all outperformance is sustainable. That is not necessarily true.

STICK TO YOUR BASIC STRATEGY, UNLESS YOU HAVE STRONG REASONS

Remember, there is nothing like you cannot change your strategy. It is just that you need a very strong and sound reason for changing your strategy. The mere success of one part of the strategy in a couple of quarters is not reason enough. That could happen with any sector. Just chasing past winners is going against the basic grain of investing, which is all about the future. That is where you need to be wary of the mismatch!

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