SCOTT WELSH TRADING BLOG

The Difference Between A Guide And A System

The Difference Between A Guide And A System

Apr. 23, 2014

A number of years ago, one of my colleagues told me his brother was coming to town and wondered if I would be able to give him a few lessons. The interesting part was that my colleague’s brother was one of the top ten juniors in the country.

Of course I said yes, but it set up a tough situation. One, it would be awful to screw up one of the best young players in the country! Two, I was only going to see him for a few lessons over a weekend. Anything I told him would have to be helpful, of course, but it couldn’t be so detailed that he’d need to see me again. It had to be useful enough to hopefully make him better but general enough that he could gradually add to that instruction over time. As it turns out, we had some great lessons and he went on to have a great career (he went on to be ranked #1 in the nation in college and then the pro tour after that).

This situation differs greatly from what I have with my regular students. With them, I can get very specific, make big changes that will work out for the better in the long run, and adjust things along the way.

During a weekend of lessons, I can only be a helpful guide. During a consistent, ongoing relationship, my student and I can use a process geared toward short and long-term goal reaching. Big difference.

 

Last week, I finished up a series of episodes as a grateful guest-host on Rob Booker’s acclaimed Traders Podcast. In the last episode, I outlined a general way to pick stocks for a retirement account. This week I received a listener’s email questioning the effectiveness of that “system”. So I wanted to talk a little about that.

As you may know, I exclusively trade forex right now, but I started in stocks and traded them for years. I know that there are many more stock traders than forex traders, however, so I wanted to give some stock ideas on the Podcast. That’s why I brought it up in the first place, to try to help.

In the Podcast, I mentioned the Magic Formula way of investing and there is some testing available on that—but not from me because I’ve never traded it the way Joel Greenblatt recommends. I do track the Magic Formula stocks each year (and have done so since 2006), and they do pretty well. I begin my portfolio with 30 stocks in January each year and watch it through December. The only losing year so far has been 2008. Not bad.

Second, I mentioned a way to determine “Fair Value” and how money can be made trading back to Fair Value when price gets extreme. There are many ways to get the value of a stock, most of them using the financials of a company. I just use the 800 simple moving average. Any valuation of a company ends up being close to what the 800 SMA shows, and I don’t trust any company’s numbers anyway. So Fair Value to me is the 800 SMA.

If you wait for price to be far away from the 800, say 50-100%, then the chances of making 20% on your investment is pretty good. This is what Warren Buffett has done since the 1960’s and what Greenblatt is attempting to do in his book (The Little Book That Beats The Market). In fact, this is what Value Investors have been doing since the dawn of time. Value investing has worked in the past and it will continue to work in the future.

In other words, I wanted to give people a good place to start. If anyone is interested in using stocks for his/her retirement account, I wanted to guide them in a good direction.

My emailer was curious about results of trading to Fair Value, and, of course, I don’t have any. There’s no way to quantify discretionary Value Investing. Maybe I started my long trade when price was 100% below Fair Value. Maybe I started at 72% below. And maybe I took my trade out before it hit the 800 SMA for a 35% gain. Or maybe I waited. Or maybe I couldn’t stand the drawdown and took it out for a 17% loss. Or maybe I bought more of a losing trade and ended up making 100%.

Furthermore, the kind of stocks you trade matters. Penny stocks should have their own rules and Dow stocks should have their own rules. How far you allow from Fair Value and when you close the trade could change from stock to stock.

I did mention some examples in the Podcast to illustrate how it’s possible to make 20% a year Value Investing, but those examples were meant to start the investigation, not give definitive expectations. Those were just one set of rules for one particular set of stocks. I can’t tell you how much you could expect to make Value Investing. I do think you can make something, though. I’m pretty darn sure about that.

The bottom line: I wanted to give everyone a timeless investing principle that could possibly lead to helping someone’s retirement account. I was not giving out a System. And I want to make that very, very clear.

When I speak about a System, I will give you numbers. I can tell you when the greatest drawdown occurred, the winning percentage, the number of trades, the biggest winning streak, how much it made going long, how much it made going short, how much it averages per month, how much it averages per year, and on and on. A System has rules and those rules are followed without exception. A System has a statistical expectation, and there’s not anything left open for discussion.

And, for me, those Systems involve using Robots.

At the end of the Podcast, I mentioned some numbers and those were from Systems. That doesn’t mean you can’t take investing principles like Value Investing and make Systems out of them. You can. But first you need to make solid rules out of those principles and then produce some solid, ironclad testing. That’s how an idea turns into System.

So I hope I didn’t lead anyone astray with the Podcasts. I’d be happy to talk about how to turn Value Investing into a System if interest is there. But there is a difference between a guide and a System, and I hope I’ve made that clear.

Thanks for the email and I’ll see you next week. Happy trading.

 

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