Avoid Making Predictions
Avoid making predictions. The market can go up or down at any time — it is only the probability (of each move) that varies. Confirmation bias is a forecaster’s biggest enemy. If you make predictions, you are likely to emotionally commit to a position and discount evidence to the contrary. To counteract this, I try to present both bull and bear scenarios wherever practical.
Investment is not an exact science. We never know the outcome of a particular pattern or series of events in the market with 100 per cent certainty. The best that we can hope for is a probability of around 80 per cent. That means something unexpected will occur at least one in five times.
My approach is to assign probabilities to each possible outcome. Actual percentages would imply a degree of precision which, most of the time, is unachievable. Terms used are more general: “this is a strong signal”; “this is likely”; “expect this to follow”; “this is less likely to occur”; “this is unlikely”; and so on. Bear in mind that there are times, especially when the market is in equilibrium, when we may face several scenarios with fairly even probabilities.
Markets Are Not Perfect
Technical analysts often repeat the mantra: “the charts discount everything — all information available to the market is reflected in the current price”. The market takes time to react to and digest new data. We are not dealing with a vast super-computer that can detect and analyze the implications of every change in market conditions. The market is driven by mass psychology and pulses with the ebb and flow of human emotions. Emotions may respond rapidly to extreme events — and are more likely to overreact than in times of gradual change. Individuals are also seldom comfortable acting alone and are dominated by a vast herd instinct.
Broad market conditions, especially the supply and demand for money, drive market prices. If there is no money to buy stocks, prices will fall. Likewise, if the market is awash with money, prices are likely to rise.
Technical analysis acts as a useful confirmation of fundamental views or actions (not the other way round). Never place all your faith in a single indicator. They are imperfect summaries of price and volume action. Nothing more.
Analysis should also be separated into three time-frames: short, intermediate and long-term. While one time frame may be clear, another could be uncertain. Obviously, we have the greatest chance of success when all three time-frames are clear.
A Simple Formula
The market is a dynamic system. I often compare trading to a military operation, not because of its oppositional nature, but because of the complexity, the continual uncertainty, conflicting intelligence reports, and the element of chance that can disrupt even the best made plans. Prepare thoroughly, but allow for the unexpected. The formula is simple. Invest when probabilities are in your favor and apply proper risk management — and you will succeed.