No. of Recommendations: 4
The “average” investor is an idiot who’s going to lose money. That’s his God-given purpose in life, and nothing is going to change that *except* his choosing not to be “average” and then doing whatever it takes to make that change happen, the chief of which is going to be writing a credible business plan, and the chief component of that plan will be his risk-management rules, the chief of which will go something like this. “You’re wrong if you’re long and the price is falling.”

But by how much does a price have to fall (or rise if you’re short) before the position should be sold? That’s the hard part, right? What distinguishes normal price fluctuations from price moves that are significant? Do you get out when prices decline/rise by 5%? By 10%? By 20%. Or do you use some other performance metric such as Rate of Change and get out (or in) when momentum favors doing so?

What the average investor fails to do is create a set of rules for himself that tell him when to buy (or sell short) and when to close out that position. They hope for what they want to see happen instead of looking at what prices are actually doing, which could be one of five things: up or down a bit, up or down a lot, or mostly going sideways. Of those five types of market conditions, only one is difficult to manage, but even sideways markets can be dealt with by sticking to one’s rules.

Whipsaws aren’t comfortable. But they’re just a cost of doing business, and they are nothing that can be avoided entirely. However, they can be minimized by not making any move (in or out) unless there is strong evidence for making the move. Reducing the losses caused by whipsaws is the upside of demanding strong evidence. The downside is the probable reduction in profits caused by lagged entries and exits. So that’s the tradeoff. ‘Slow in’ and ‘slow out’ means fewer whipsaws, and such an approach is as good as any for distinguishing ‘investors’ from ‘traders’, never mind the fact that it is a distinction without a difference due the fact that market time is fractal.

But making a distinction between ‘investors’ and ‘traders’ has psychological validity, and for that reason, it is useful. Some people can make decisions quickly under conditions of uncertainty, and they are ‘traders’ in every sense of that word. Some people prefer a more leisurely approach to decision making, and they really are ‘investors’ in the best sense of that word. Thus, you could be a ‘trader’ whether you are trading off of charts based on 15-second bars or weekly bars. The time frame doesn’t matter. If you’re constantly probing, constantly looking for entries, and if you are willing to reverse instantly when proven wrong, then you aren’t an ‘investor’. You just don’t have their temperament, which is Not a Bad Thing.

OTOH, if a market move has to be so obvious to you that there seems to be no risk in it, then you’re not an ‘investor’. You’re just an idiot, and you deserve every loss you will suffer for not the good sense to leave the party when things get ugly. So that becomes another way by which traders and investors can be distinguished. Typically, traders will leave too soon, and investors will leave too late. So, let’s chart a middle course, and let’s adapt some of the tools traders use to the psychological needs of investors.

MACD is a momentum indicator constructed from a moving average of the difference between two moving averages. Based on Lane’s work, the customary defaults are (12, 26, 9). But those parameters can be changed, and doing so eliminates a lot of the whipsaws. Exactly which parameters you choose will depend on your temperament and purposes. But take a look at (20, 40, 20) on a chart based on daily bars and see if it works better for you than the customary version, especially for timing entries and exits from mutual funds.

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