Table 1.12 Compounded gains made from 20 consecutive transactions for different gain levels per transaction. It is assumed that there are 16 winners and 4 losers. The loss for the losers is the same as the gain for the winners
Being realistic, therefore, we have to downgrade our expectations for profit from the levels we have been using for the calculations in the previous tables. Firstly, we will make the assumption that the maximum gain per transaction after dealing costs will be 20%, i.e. using a round number slightly higher than the 17.94% which we showed previously would follow from perfect timing. Secondly, we will make the assumption that we are correct eight times out of ten, and for simplicity, when we are wrong, we will lose the same percentage that we make when we are correct. Thirdly, we will assume that the investor makes ten consecutive transactions, reinvesting the proceeds each time. Table 1.12 shows the resulting gains for such a series of investments where the gain (and loss), after dealing costs are taken into account, varies from 20% down to 1% per transaction.
These compounded gains run from 657%, i.e. multiplying our starting capital by 7.57 when we achieve a 20% gain per winning transaction and a 20% loss for losing transactions, down to 12.6% where we only achieve a 1% gain or loss. To double our capital over these 20 transactions we need to reach the level of just over 6% per transaction. Note the improvement made for each additional 1% that can be squeezed out. Thus the investor reaching 7% per transaction will do 20% better overall than the investor reaching 6%.
Most of this book is dedicated towards improving the timing of buying and selling operations to such an extent that we should be able to capture gains of around 8 to 10% (after dealing costs) from each of those transactions which we have correctly forecast, while restricting our losses to similar levels from each of those transactions where the forecast goes wrong. From Table 1.12 it can be seen that this means that our capital will increase by a factor of two and a half to three times after 20 such transactions. The remainder of this book is dedicated towards improving the performance of investors so that they can make these extra few percentage points out of each rise. Investors will be able to concentrate on the shorter-term trends such as the 12-week trends we have been discussing for Grand Metropolitan. Techniques will be shown that enable the best shares to be selected to take advantage of these short-term trends. Techniques will also be shown that enable the investor to buy in very early in the life of the uptrend and sell not too far down from the end of the trend. It is suggested that investors develop a five-year horizon. In this time period, there will be between 20 and 25 transactions in just one share if trends of the order of 12 weeks are used. The investor who wishes to become more deeply involved can be invested simultaneously in a number of shares, subject to the restrictions mentioned in the final chapter.
In summary we can make the following points:
Share prices consist of upward and downward trends of varying lengths of time.
These trends fall into various categories, including those that last on average less than three weeks, those that last on average about 12 weeks and those that last on average just under one year.
Average investors should make gains of about 10% out of trends which last on average for 12 weeks.
By compounding such gains, average investors should be able to multiply their capital by about three over a series of 20 such transactions.
Channel analysis will improve performance so that gains of many tens of times are possible over a long term if a full investment strategy is pursued as far as is practicable.
Chapter 2. The Nature of Share Price Movement
INTRODUCTION
There has always been controversy over the way in which share prices move over the course of time, with chartists maintaining that prices can be predicted to a certain extent because historical patterns in the charts of share prices tend to recur from time to time. These methods of analysis rest heavily on the recognition of the start of a pattern formation so that the subsequent movement can be anticipated. On the other hand, the fundamentalists believe that the key to investment success lies in such factors as the way in which a company is managed, the quality and appeal of its products, and the strength or weakness of its balance sheet.
They believe for the most part that chartist techniques are just mumbo-jumbo and that the past history of share price plays no part in the future movement. If pressed about the nature of share price movement, many fundamentalists would state that they believe that share prices move on a random basis and therefore cannot be predicted. In doing this, they ignore the obvious corollary: if prices move randomly, there is no advantage in studying the fundamentals of any company since the random share price will bear no relationship to these fundamentals.
While fundamentalists are for the most part hostile to chartists, the reverse is not true. Chartists will agree that there should be some relationship between the way in which a company is run and its future share price. Certainly it would be unreasonable to expect that a company that is continually making losses will show a strong share price. Chartists are of the opinion that all the positive aspects of a company’s performance are reflected in the share price, and therefore an analyst can take a shortcut by looking at the share price and not the fundamentals. This author stands with the chartists on this point about the relationship between the share price and the fundamentals, believing that what moves a share price upwards is not the quality of the management or the products or the balance sheet, but investors’ views about the company’s potential. Some investors’ views may indeed be influenced strongly by the fact that they have carried out an analysis of the company’s balance sheet or market strengths. Other investors may simply have read comments in the press. Yet others may have applied some technical analysis of the share price chart and come to a conclusion about the future movement of the share price. It is the sum total of these different views, many of which will be contradictory, that will add up to the pressure in the marketplace that will cause the share price to move. When all views are the same, the price will move rapidly, while if they are nearly in balance, the price will drift more or less sideways. Grafted on to all of this will be the views of the market makers, since they have to balance their books also. There will be some shares which attract no comment and attract no technical analysis because they have generated no excitement in the past. In such cases, therefore, it is unreasonable, however strong the fundamentals are, to expect the share price to move upwards.
This author takes the position that everything an investor needs to know about a company is stated in its share price movement. It will be simpler and quicker for an investor to discover how to analyse share price movement than to study the company itself, and the result of this price analysis will tell the investor the most important fact: how other investors feel about that company.
Where this author does not stand with the chartists is in their simplistic approach to share price analysis. In its most trivial form chartism depends upon sets of rules which have to be followed without any other understanding. Thus the chartists will make statements such as “buy when the share price moves above the x-day moving average,” where x depends upon the chartist you are speaking to, or “sell when the ten-day average falls below the twenty-day average.” Such a set of blind rules should play no part in the thinking man’s investment armamentarium. The human race has always striven to understand the reasons for the behaviour of the physical world, and share price movement should be no exception. A Pavlovian response to a set of circumstances will ultimately lead to disaster, since the stock market is always ready with the unexpected. Experienced chartists can probably correctly predict whether a share price will move up or down about 55% of the time, but this means they are wrong about 45% of the time. The dangers of a set of rules which work only just over half of the time are obvious. Investor psychology is such that the investor is always trying to avoid selling a holding in the belief that an adverse movement is only a minor aberration in the expected upward trend, and will surely correct itself before too long. Nearly all investors have seen a good paper profit from a good buying decision evaporate