Where is my crystal ball?

New traders often look for a foolproof system, or indicator, that can deliver constant returns, or foretell the future. The real truth is that there is no such thing, and that discipline is the most important skill to acquire.

US trader
Source: Bloomberg

The latest dip in the Nasdaq 100, sparked off by a Goldman Sachs note, could well be the latest dip in a strong rally that will be bought by investors, with the index then driving on to all-time highs. Then again, it may be the start of something bigger, as investors finally begin to worry about overheated valuations that may not be justified. We simply do not know.

Trends tend to go on longer than anyone thinks possible. Markets overshot to excessive highs in 2000 and 2007, and overshot to the downside in the following panics. The mining sector fell to a level in early 2016 that resulted in some of the world’s largest mining companies trading at ridiculously cheap valuations. But it could well have gone on much longer. The lesson to learn with trends is that you have to ride them until the end, even if it means missing out on some profits as the turn begins.

Similarly there is no point trying to second guess when a turn has arrived; it is more dangerous to try to call a top or a bottom than it is to simply take opportunities when the trend undergoes a retracement (ie when there is a dip in an uptrend or a short-term bounce in a downtrend).

This is not complicated, or particularly clever. Cleverness and the use of complex strategies usually gets traders into sticky situations. The history of trading is full of those that failed because they tried to be too clever, or tried to predict what the market will do next. There will have been many that tried to call the top in the secular bull market that went from 1983-2000, and there have been plenty that have tried to pronounce the obsequies of the rally in the Nasdaq from 2009 until today. Where are they now?

It won’t get a trader much news coverage, but it will save them from doing the wrong thing. Warren Buffett’s great friend and investment partner Charlie Munger said that they don’t try to be too clever. Instead, they do the ‘less stupid’ thing. In long-running uptrends such as we are seeing in many equity markets, the ‘less stupid’ thing to do is to buy the dip. Eventually a dip will come along that turns into a new big downtrend, but that may not arrive for a long time yet.

Buying the dip won’t work every time, but when it doesn’t, good risk management, such as the oft-repeated but still valid chestnut about not risking more than 2% on a trade, will help limit losses.

The great secret about ‘crystal ball trading’ is that there is no crystal ball.

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