What makes a good first impression?
For me, it’s eye contact and a firm handshake.
Others focus on appearance. They look at things like a person’s clothes, shoes, watch, jewellery or makeup. These all say something about you.
First impressions need little thought — they are almost instinctive. This makes them a useful mental shortcut. They can save you time and effort.
But should you rely on them?
Well, no, according to Daniel Kahneman, a Nobel Prize-winning author and psychologist.
Kahneman points to our mind’s tendency to simplify. He says the mind deals with what we know, and avoids seeking complicating facts. The easiest option is to believe what we see.
There’s a name for this type of thinking. Kahneman calls it, ‘What you see is all there is’. Essentially, we’ll make up an entire story from a few strands of information.
And it’s true. Let me give you a real life example…
I want you to picture a man in his mid-50s. He owns a house in Mosman — an exclusive harbourside suburb in Sydney. He’s also got a Ferrari in the garage and a weekender in the country.
Tell me. What is your first impression?
Chance are you think he’s rich — all the outward signs say so.
But do you know what? It’s a wealth mirage. His net worth is around $100,000.
A friend of mine, Rod, told me about this guy. You see, Rod owns a boutique insurance business for exotic cars…and the Ferrari’s insurance was with his company.
So how does Rod know his client’s financial position?
Well, someone stole the Ferrari. The first thing the insurance company does in cases like this is to get a statement of assets and liabilities. The insurer is basically looking for signs of fraud.
The client’s balance sheet was telling. The expensive assets were offset by a mountain of debt. The glue holding it all together was a high income. Rod says he sees this situation a lot.
First impressions are just an initial observation. They don’t tell you the whole story. You need to look below the surface to get a true picture of what’s going on.
A quick recap
Last week, I told you about Quant Trader’s performance. You saw how the system is tracking in comparison to the All Ordinaries. Let me show you the chart again…
Quant Trader (the blue line) is outpacing the All Ordinaries. This assumes $1,000 on every long trade, and doesn’t account for dividends or costs. You can read more about the methodology here.
Performance charts can be fascinating. They condense a lot of information into a single line. But like first impressions, they don’t tell you everything. You need to dig deeper to get the full picture.
This week, I’m going to explain some of the data behind the chart. I want you to see how the system works. It’s good to know a strategy is profitable, but you should always ask why.
You see, ‘understanding’ is the key to successfully ‘doing’. My confidence always gets a boost when I know what’s going on. (It also helps me avoid false impressions, like in the case of Rod’s client.)
It’s the details that matter
Quant Trader currently has 213 open long trades. These range from a gain of 272.7% to a loss of 21.7%. The average open trade is currently up 21.6%. (All figures are for COB 28/7/16.)
Think about those these numbers for a moment. The best stock is up 272.7%, while the worst result is down 21.7%. The winner is more than 12 times larger than the losing trade.
What do you think causes this lopsided outcome?
It’s really quite simple: Quant Trader runs profits and cuts losses. The key is to keep upside open, while limiting losses. That’s what leads to the disproportional results.
But let’s go even deeper. There’s another layer of data you’ll find interesting.
Have a look at the following table. It shows the distribution of profits and losses since live signals began. It includes all open and closed long trades — there are 487 in total.
Heading the list are the top quarter of trades — these are the best 122 positions. The next rungs down are the middle tier stocks. The final quarter holds the worst performers.
The result is as I’d expect. The middle quarters net out and leave a modest gain. But it’s the top group that matters. These stocks cover the remaining losses, and deliver the outperformance.
This is how trend-following systems typically work. You make your money by letting winning stocks run…and some of these can run a very long way.
A key element of the strategy is to spread your trades. This increases the odds of getting a selection of top tier stocks. These are the ones that can really boost your returns.
Now think about this. Many traders like to lock in relatively small profits. This caps a stock’s upside potential — it can never become a big winner.
Imagine this table without the top 25%. It would drastically impact profitability. This is what happens when you cut your winners short.
The key to success is how you handle each tier of stock. Good trading is about protecting capital and maximising profits. Quant Trader can help you do this.
Let me show you what I mean…
This is a chart for technology business Data#3 [ASX:DTL]. There have been two buy signals for this stock — at $1.06 and $1.25. Signal 2 is currently in the bottom quarter of trades.
Quant Trader’s strategy involves buying into strength. You can see that’s exactly what happened in this case. DTL had solid upward momentum.
While this tactic improves the odds of success, it’s no guarantee. Good trading deals in probability, not certainty. This is why capital preservation is vital.
Quant Trader’s stop-loss for DTL is at $0.79. This is our line in the sand. It’s the point at which we cut our losses and walk away.
Let me show you one more trade.
Aristocrat Leisure [ASX:ALL] is also in the Quant Trader portfolio. There have been three buy signals for the gaming company — at $6.85, $7.82 and $9.04.
You can see the entry points on the chart. The shares were rising strongly on each occasion — just like DTL. But that’s where the similarity ends; Aristocrat remains in an uptrend.
The initial signal is up 91%. This puts it in the top performance tier. Quant Trader’s strategy is to maximise profits. This means there’s no cap on how far this trade can go.
First impressions are a glimpse of a possible reality. They tell us a little, but leave out a lot.
Quant Trader’s performance chart is a case in point. Some people see it and think every trade will double in price. Nothing could be further from the truth — trading just isn’t like that.
Yes, Quant Trader is performing well. But that doesn’t make every signal a winner. Some will inevitably fail. We sell these stocks and move on.
The secret to Quant Trader’s strategy is letting the best trades run. These are the ones that make most of the money. I hope you’re having similar success in your own portfolio.
Until next week,
Editor, Quant Trader
Editor’s note: Are you falling short of your goals? Do you find it a struggle to consistently make good profits? Don’t worry, you’re not alone. The stock market can be a tough place to navigate on your own.
Here’s something you should do — check out Jason McIntosh’s Quant Trader advisory service. It’s a fully algorithmic trading system for ASX stocks. Quant Trader scans practically every company. It then tells you when to buy and sell. I can just about guarantee you’ve never heard of some of the stocks it identifies.
Try it. See if it makes sense to you. It could change the way you trade forever.
Quant Trader sources all graphs and images above.