Three Trading Models You Need to Know

If only you had a model that spat out stock names to buy.

It’s not that we haven’t tried. You can find computer models all over the financial world.

But most fail to deliver.

Take hedge funds for instance. Many macro funds use computer models to calculate correlations, and weighting of various assets.

The idea is to create a portfolio that does well even if ‘Event A’ occurs in the economy. The aim is to outperform, regardless of economic events.

Some do OK. But most can’t stand up to Father Time. The same goes for any model trying to predict market values.

How can the experts get it wrong so often?

Maybe the problem is that models use numbers to predict human behaviour? God knows, we’re not always rational creatures, especially when money is involved.

With the aim to make Money Morning readers like you better investors, I thought I’d share some models that actually work.

No need to break out a spreadsheet. All the models I’m about to show you only require your attention.

People associate price with value

One day, an owner of an Indian jewellery store stumbled upon an ingenious way to move jewellery.

She increases prices.

That’s right. Anything that’s not selling flies out the door once marked up.

If you’re the economist type, this probably sounds strange. Why would increasing the price increase demand?

Surely jewellery is a very elastic product? Meaning demand depends heavily on price.

Yet when tourists wonder into this Indian jewellery store, they go crazy for high priced turquoise. After a while, she decided to get an answer as to why this was the case.

She called her friend and psychologist, Robert Cialdini.

If this story sounds familiar, it’s because I’ve told it in Money Morning before.

Cialdini told his friend that people were buying the turquoise at a higher price because they perceived it as more valuable.

Luxury brands employ the same techniques to create demand for their products. Take Tiffany & Co. [NYSR:TIF].

The only difference between a diamond ring at Tiffany’s and someplace else is the logo on the ring and the little blue box.

But does that matter? Not at all. People still line up and pay much more for the Tiffany brand because they perceive it as having more value.

This is the first mental model worth knowing. People associate price with quality/value.

The power of association

The second is the power of association.

To explain, let’s turn to a name you’re all familiar with — Pavlov.

We all know Pavlov and his dog yeah?

The Russian psychologist would often ring a bell while giving his dog food. After a while the dog formed an association with the bell and food. So now every time Pavlov rings the bell his dog starts salivating.

You can see the same model at work in almost all advertising campaigns.  Take Coca-Cola for instance. Their core product isn’t unlike any other drink on the shelf. So why do people by more Coca-Cola than anything else?

Rather than using the first model, Coke has built their brand around association. They’ve associated Coca-Cola with happy feelings, positive events and memorable moments.

This didn’t happen overnight. It took years, if not decades, to get people to think of Coca-Cola as something enjoyable and positive.

Frequency illusion

The last model I want to share is confirmation bias.

Have you ever planned to buy a new car and then immediately start seeing that same car all over the place? Maybe you read that your lucky numbers were 88 and now you start seeing 88 everywhere.

Is the universe trying to tell you something?

Psychologists call this frequency illusion — you frequently observe something once it’s introduced to your mind.

But it doesn’t stop there.  More often than not your mind will actively look for that car or the number 88 rather than waiting for them to appear.

If we relate this to an idea, you might come to a conclusion and then start looking for evidence to support that idea.

It’s why people tend to listen to ideas that are similar to their own. It’s more evidence to strengthen their initial findings.

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How do these trading models make you a better investor?

Let’s look at the first model: associating price with quality/value.

It a tactic many businesses use.

So what happens when a business changes their strategy of high prices to low?

We don’t have to hypothesise. We’ve seen brands do exactly that. In 2014-15, companies like Michael Kors and Ralph Lauren started to open a bunch of outlet stores.

The idea was to get more product out there, increasing sales long-term. These outlet stores would usually sell products at a cheaper price.

As a result, consumers saw them as ‘discount stores’.

Consumers could buy the quality Michael Kors or Ralph Lauren brand, but didn’t have to pay the department store prices.

This immediately ruined the quality brand of Michael Kors and Ralph Lauren. No longer were these high priced items a luxury you had to have. They were just like every other bag, shirt or watch on the market.

Using this mental model, you might have gotten out of both Michael Kors and Ralph Lauren when the stocks both tumbled more than 60%.

MoneyMorning 30-07-18

Source: Bloomberg
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Moving onto the second model (the power of association), its one you can also use to make better investment decisions.

For example, imagine you’re looking at two companies. They’re both producing a similar good or service. The only difference is that one spends a lot on advertising that targets desires where the other doesn’t.

An example could be Plus500 Ltd [LON:PLUS], the CFD trading platform.

They don’t offer anything different as a CFD provider. Yet the stock has more than doubled this year while competitors haven’t even climbed half that.

What’s the reason for Plus500’s outperformance? They do a better job of associating their trading platform with quick huge gains. This brings on more customers and leads to high earnings growth.

It’s all thanks to targeted ads and the power of association.

OK, so what about the last model: confirmation bias. How does this make you a better investor?

Imagine you were looking at a stock to buy. From the outset the business ticks all the preliminary boxes. Earnings and cash flow are growing. The company doesn’t have too much debt. And they operate in a massively growing market.

The only problem is the stock price is unusually high.

You decide to side step that and keep digging. You find even more evidence that the company is wonderful, and convince yourself that growth is basically guaranteed.

So instead of looking for conflicting evidence, you’ve gone ahead and bought the stock.

It sounds silly as you read it now. But caught up in emotions and the fear of missing out, investors do this all the time.

A whole world of trading models to explore

Hopefully I’ve convinced you to use and apply the three mental models above.

But they are just three of hundreds. There’s a whole world of models to learn and use. Some you can learn in five minutes. Others take years to understand.

With any luck, these models will help you avoid market pitfalls and potentially generate massive returns over time.

Your friend,

Harje Ronngard,
Editor, Money Morning

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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