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When I first started studying investing the literature I was reading pointed me towards something called technical analysis. As I started asking questions about this trying to determine exactly what this meant, I started to discover that technical analysis is actually a somewhat controversial investment strategy. So, my question is what strategies are out there, what defines them, and why would anyone choose one over another?

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There are two umbrellas in investing: active management and passive management.

Passive management is based on the idea "you can't beat the market." Passive investors believe in the efficient markets hypothesis: "the market interprets all information about an asset, so price is equal to underlying value".

Another idea in this field is that there's a minimum risk associated with any given return. You can't increase your expected return without assuming more risk. To see it graphically:

Markowitz efficiency frontier

As expected return goes up, so does risk. If we stat with a portfolio of 100 bonds, then remove 30 bonds and add 30 stocks, we'll have a portfolio that's 70% bonds/30% stocks. Turns out that this makes expected return increase and lower risk because of diversification.

Markowitz showed that you could reduce the overall portfolio risk by adding a riskier, but uncorrelated, asset! Basically, if your entire portfolio is US stocks, then you'll lose money whenever US stocks fall. But, if you have half US stocks, quarter US bonds, and quarter European stocks, then even if the US market tanks, half your portfolio will be unaffected (theoretically). Adding different types of uncorrelated assets can reduce risk and increase returns.

Let's tie this all together. We should get a variety of stocks to reduce our risk, and we can't beat the market by security selection. Ideally, we ought to buy nearly every stock in the market so that So what's our solution? Why, the exchange traded fund (ETF) of course!

An ETF is basically a bunch of stocks that trade as a single ticker symbol. For example, consider the SPDR S&P 500 (SPY). You can purchase a unit of "SPY" and it will move up/down proportional to the S&P 500. This gives us diversification among stocks, to prevent any significant downside while limiting our upside.

How do we diversify across asset classes? Luckily, we can purchase ETF's for almost anything: Gold ETF's (commodities), US bond ETF's (domestic bonds), International stock ETFs, Intl. bonds ETFs, etc. So, we can buy ETF's to give us exposure to various asset classes, thus diversifying among asset classes and within each asset class. Determining what % of our portfolio to put in any given asset class is known as asset allocation and some people say up to 90% of portfolio returns can be determined by asset allocation.

That pretty much sums up passive management. The idea is to buy ETFs across asset classes and just leave them. You can readjust your portfolio holdings periodically, but otherwise there is no rapid trading.

Now the other umbrella is active management. The unifying idea is that you can generate superior returns by stock selection. Active investors reject the idea of efficient markets.

A classic and time proven strategy is value investing. After the collapse of 07/08, bank stocks greatly fell, but all the other stocks fell with them. Some stocks worth $100 were selling for $50. Value investors quickly snapped up these stocks because they had a margin of safety. Even if the stock didn't go back to 100, it could go up to $80 or $90 eventually, and investors profit.

The main ideas in value investing are: have a big margin of safety, look at a company's fundamentals (earnings, book value, etc), and see if it promises adequate return. Coke has tremendous earnings and it's a great company, but it's so large that you're never going to make 20% profits on it annually, because it just can't grow that fast.

Another field of active investing is technical analysis. As opposed to the "fundamental analysis" of value investing, technical analysis involves looking at charts for patterns, and looking at stock history to determine future paths. Things like resistance points and trend lines also play a role. Technical analysts believe that stocks are just ticker symbols and that you can use guidelines to predict where they're headed.

Another type of active investing is day trading. This basically involves buying and selling stocks every hour or every minute or just at a rapid pace. Day traders don't hold onto investments for very long, and are always trying to predict the market in the short term and take advantage of it. Many individual investors are also day traders.

The other question is, how do you choose a strategy? The short answer is: pick whatever works for you. The long answer is:

  1. Day trading and technical analysis is a lot of luck. If there are consistent systems for trading , then people are keeping them secret, because there is no book that you can read and become a consistent trader. High frequency trading (HFT) is an area where people basically mint money, but it s more technology and less actual investing, and would not be categorized as day trading.

  2. Benjamin Graham once said:

    In the short run, the market is a voting machine but in the long run it is a weighing machine.

Value investing will work because there's evidence for it throughout history, but you need a certain temperament for it and most people don't have that. Furthermore, it takes a lot of time to adequately study stocks, and people with day jobs can't devote that kind of time.

  1. So that leaves us with passive management. This is, in my opinion, the best idea for individual investors. That's because most active management firms actually underperform the market (both in the short and long run), and individuals can't dedicate the time necessary to become great investors (most can't).

So there you have it. This is my opinion and by no means definitive, but I hope you have a starting point to continue your study. I included the theory in the beginning because there are too many monkeys on CNBC and the news who just don't understand fundamental economics and finance, and there's no sense in applying a theory until you can understand why it works and when it doesn't.

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If you say technical analysis / day trading is just luck, do you also mean to say that books like this amazon.com/Forex-Patterns-Probabilities-Strategies-Range-Bound/… are scams? – Pacerier Nov 27 '13 at 8:04
    
Excellent, apart from your one comment "Day trading and technical analysis is a lot of luck." – Marcus D Apr 26 at 12:17
    
One other comment: some of us do passive trading because even if one could beat the market, we believe doing so would burn enough of our time and attention that the additional gains are unlikely to repay what those personal resources are worth to us. I value my hobby time at $40/hour, for things I enjoy doing. Having to do something I don't enjoy pushes the value of that time much higher. Since I don't enjoy micromanaging my money, it would take high probability of very significant additional returns to make active management worth considering... and I don't like the odds. – keshlam May 7 at 21:57
    
@pacerier: I cite my father's observation, as the ad man for a major stock market statistics product: He could not imply that the product would actually be useful to the investor, due to the risk of false-advertising laws. He could call it "The Information You Want", because by definition if they were buying it they wanted it, whether their reasons for wanting it were well-founded or not. I'll also point out that if the things disclosed in the books worked at all reliably, the authors would be rich enough not to need income from a book. – keshlam May 7 at 22:04

Your question seems to be making assumptions around “investing”, that investing is only about stock market and bonds or similar things. I would suggest that you should look much broader than that in terms of your investments.

Investment Types

Your should consider (and include) some or all of the following for your investments, depending on your age, your attitude towards risk, the number of dependents you have, your lifestyle, etc.

  • Life insurance, disability insurance, unemployment insurance (note I’m not an insurance broker, just think there is value in some of these, for some people, some of the time)
  • Property. Owning a property depending on the country and the tax laws can make this a good medium to long term investment. Multiple properties can be quite valuable in terms of the buy-to-let market. These are usually illiquid assets that in the long term have a capital gain.
  • Investment in a business. Owning or investing in a business that you can put your personal skills and expertise into is a great way to earn money and build value. Also generally medium to long term, though with online business, medium tern can be 3-5 years.
  • Stocks and shares. These can be traded anywhere from high frequency trading, day trading, trading (weeks-months), investing (often years)
  • Government or corporate bonds. These can be traded much as stocks and shares are, or can be bought and held, receiving the interest as per the bond description.
  • Commodities. I know of individuals who buy and sell precious metals – Au, Ag, Pt. Im sure others are possible, often these are over a time frame of months to years
  • ETFs, which can be in almost any stock, share, index, bond or commodity, these can be traded in the same frequency as stocks and shares, though haven’t been around very long so they haven’t been owned for many years yet.
  • Futures, options and other derivatives. These are traded similarly to stocks and shares.
  • Foreign exchange trading. These can be used as a hedge for business, but are traded in HFT, day trading and short term (days-weeks).
  • Premium Bonds (http://www.nsandi.com/), a UK special 'investment' that is capital guaranteed, but the bond holder is entered into a lottery that may “pay out” if you are a winner. A very strange beast, but was recommended to me as being better than cash by an investment broker due to the current low interest reates!

I love @Blackjack’s explanation of diversification into other asset classes producing a lower risk portfolio. Excellent! All the above need to be considered in this spread of risk, depending as I said earlier on your age, your attitude towards risk, the number of dependents you have, your lifestyle, etc.

Stock Market Investment

I’ll focus most of the rest of my post on the stock markets, as that is where my main experience lies. But the comments are applicable to a greater or lesser extent to other types of investing.

We then come to how engaged you want to be with your investments. Two general management styles are passive investment management versus active investment management. @Blackjack says

That pretty much sums up passive management. The idea is to buy ETFs across asset classes and just leave them.

The difficulty with this idea is that profitability is very dependent upon when the stocks are purchased and when they are sold. This is why active investing should be considered as a viable alternative to passive investment.

I don’t have access to a very long time frame of stock market data, but I do have 30 or so years of FTSE data, so let’s say that we invest £100,000 for 10 years by buying an ETF in the FTSE100 index. I know this isn't de-risking across a number of asset classes by purchasing a number of different EFTs, but the logic still applies, if you will bear with me.

Passive Investing

I have chosen my example dates of best 10 years and worst 10 years as specific dates that demonstrate my point that active investing will (usually) out-perform passive investing.

From a passive investing point of view, here is a graph of the FTSE with two purchase dates chosen (for maximum effect), to show the best and worst return you could receive. Note this ignores brokerage and other fees. In these time frames of data I have …

  • Best return if you happen to buy your stocks at April 2003 and sell at March 2013. The return is 23% profit
  • Worst return if you happen to buy your stocks at July 1999 and sell at June 2009. The return is a 32% loss

15 Years of Monthly FTSE stock data

These are contrived dates to illustrate the point, on how ineffective passive investing can be, depending if there is a bear/bull market and where you buy in the cycle. One obviously wouldn’t buy all their stocks in one tranche, but I’m just trying to illustrate the point.

Active Investing

Let’s consider now active investing. I use the following rules for selling and buying:-

  • Buy the ETF (or continue holding the EFT) when the 3 month moving average of monthly close price is greater than the 7 month moving average of close price.
  • Sell the ETF (or stay in cash) when the 3 month moving average of monthly close price is less than the 7 month moving average of close price.

This is obviously a very simple technical trading system and I would not recommend using it to trade with, as it is overly simplistic and there are some flaws and inefficiencies in it.

So, in my simulation,

  • For the worst 10 year period, I did a total of 16 trades and made a profit of 21%
  • For the best 10 year period, I did a total of 15 trades and made a profit of 71%

These beat the passive stock market profit for their respective dates.

Summary

Passive stock market investing is dependent upon the entry and exit prices on the dates the transactions are made and will trade regardless of market cycles.

Active stock market trading or investing engages with the market using a set of criteria, which can change over time, but allows one’s investments to be in or out of the market at any point in time.

My time frames were arbitrary, but with the logic applied (which is a very simple technical trading methodology), I would suggest that any 10 year time frame active investing would beat passive investing.

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