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| - | ===== Dow Theory ===== | + | ==== Dow Theory ==== |
| There is also proof that one of the oldest systems around can outperform the market and reduce risk. [[:market_analysis:dow_theory|Dow Theory]] seeks to buy when both the Dow Transports and the Dow Industrials record new reaction highs and sell or move into treasuries when both record new reaction lows. The move out of stocks and into treasuries greatly reduces risk because one is not exposed to riskier stocks. There have been a few big bad bear markets over the years and preserving capital is one of the keys to investment success. | There is also proof that one of the oldest systems around can outperform the market and reduce risk. [[:market_analysis:dow_theory|Dow Theory]] seeks to buy when both the Dow Transports and the Dow Industrials record new reaction highs and sell or move into treasuries when both record new reaction lows. The move out of stocks and into treasuries greatly reduces risk because one is not exposed to riskier stocks. There have been a few big bad bear markets over the years and preserving capital is one of the keys to investment success. | ||
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| - | ===== Fat Tails and Trends ===== | + | ==== Fat Tails and Trends ==== |
| Historic stock returns are not normally distributed. What does this mean? If one were to measure the height of 1000 people and plot the distribution, this distribution would form the classic bell curve. The most recurring height (value) would be in the middle and the remaining heights would be equally distributed on either side. Furthermore, 68.5% of all values would fall within ±1 standard deviation of the mean, 95.4% would fall within ±2 standard deviations and 99.7% would fall within ±3 standard deviations. The solid black line shows a typical bell curve with a normal distribution. | Historic stock returns are not normally distributed. What does this mean? If one were to measure the height of 1000 people and plot the distribution, this distribution would form the classic bell curve. The most recurring height (value) would be in the middle and the remaining heights would be equally distributed on either side. Furthermore, 68.5% of all values would fall within ±1 standard deviation of the mean, 95.4% would fall within ±2 standard deviations and 99.7% would fall within ±3 standard deviations. The solid black line shows a typical bell curve with a normal distribution. | ||
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| Statisticians have found that a distribution of stock returns forms a curve with "fat tails". In a normal distribution, 99.7% of all these returns would be within ±3 standard deviations of the mean. This, however, is not the case for stock returns. Instead, the distribution has fat tails, shown in the dotted lines on the graphic above. This means a relatively high number of returns fall outside the normal distribution. Some are lower and some are higher. These abnormal returns provide evidence of extended moves, outsized moves or trends. Note that the image above is just a hypothetical example to illustrate a point. | Statisticians have found that a distribution of stock returns forms a curve with "fat tails". In a normal distribution, 99.7% of all these returns would be within ±3 standard deviations of the mean. This, however, is not the case for stock returns. Instead, the distribution has fat tails, shown in the dotted lines on the graphic above. This means a relatively high number of returns fall outside the normal distribution. Some are lower and some are higher. These abnormal returns provide evidence of extended moves, outsized moves or trends. Note that the image above is just a hypothetical example to illustrate a point. | ||
| - | ===== Visual Evidence ===== | + | ==== Visual Evidence ==== |
| Anyone who has followed the stock market for any length of time realizes that trends can and will take hold. To be fair, not all stocks trend and trends do not last forever. However, there are enough asset classes, major indices, sectors, industry groups or stocks out there to ensure that something is trending at some point. The challenge, as always, is to find that trend and ride it. The next three charts show some individual stocks with clear signals and trends. Identifying a simple double top and getting out of Citigroup (C) would have avoided a whole lot of pain. The same can be said for Enron, Worldcom and the few other debacles. | Anyone who has followed the stock market for any length of time realizes that trends can and will take hold. To be fair, not all stocks trend and trends do not last forever. However, there are enough asset classes, major indices, sectors, industry groups or stocks out there to ensure that something is trending at some point. The challenge, as always, is to find that trend and ride it. The next three charts show some individual stocks with clear signals and trends. Identifying a simple double top and getting out of Citigroup (C) would have avoided a whole lot of pain. The same can be said for Enron, Worldcom and the few other debacles. | ||