Some rules are meant to be broken, but for what its worth here is a list of rules of thumb that i try to follow, often due to painful experiences doing the opposite of them. They essentially create a strategy based around contrarian, technical and value investing combined -
1) Try to avoid trading against what you think to be the primary trend – It’s hard enough to beat the market when trading, but trying to do so against the primary direction of the markets is like pissing in the wind/standing in front of a train/pick your own cliched CNBC type expression. Deciding the primary trend is of course rather fraught but its worth noting that bull markets always begin from low market P/E’s (usually in single digits for the S&P 500) and bear markets with high market P/E’s (over 20). For more on this I recommend reading John Maudlin’s Bull’s Eye Investing.
2) Buy Fear and Sell Greed – Sounds obvious but is much harder to pull off in reality. To achieve this, i tend to use indicators such as the VIX, Investors Intelligence Survey, put/call ratios and various others indicators ranging from the ‘scientific’ to the anecdotal.
3) The market can remain irrational longer than you can remain solvent – Ok this is more a quote than a rule, but it’s something that any trader should learn as soon as possible as, believe me, there is nothing worse than being right but still losing all of your money. To reduce the risks from this adage, use stop losses for each trade, usually just below siginificant support when long and above resistance when short.
4) Listen to the people you’ve learnt to trust to help with the big ideas as they are brighter than you (well me at least) – For me that currently means people like John Maudlin, Bill Fleckenstein, Bill Gross, Mark Hulbert and the site Minyanville.
5) Always read the opposing viewpoint and continually critique each of your trades – To borrow (poorly) an idea from Nassam Taleb’s black swan, find the skeptical empirist inside you and always force yourself to read the opposing view. Remember there are two sides to every trade…
6) Peter Lynch is right – you’re a consumer and/or are likely to have a day job so trading things you know about and/or want could give you an advantage when choosing stocks.
7) What Perfect Market? – Although the future market direction and/or economy may be impossible to predict to any degree, when you hear analysts say ‘this time its different’ every few years in relation to the latest fad or market bubble, it seems pretty hard to believe that the market operates at a level anywhere near perfect. I believe it to be only as good as its average participant, much like democracy, and human beings are prone to behave irrationally. If we accept and agree with this then alpha and better than market returns should in theory be extractable..
What’s the risk and reward of each trade? – this could be called risk reward management or money management and is similar to no.3 but to expand on it more you should be aware of your entry points and exit points of each trade both in the event of a winning or losing trade. If you don’t attempt to acheive some kind of risk/reward ratio before you start a trade, you’re already in trouble.
9) If you’re anything other than cautiously optimistic when trading, you’re probably doing something wrong – This works both ways. For example, if you start a trade and your emotions are approaching anything like total confidence then its a fair bet that you’re going to lose some money. If on the other hand you’re petrified, that probably indicates that your trade is either too large or too risky. Your mind and body are programmed to make you a bad trader so you need continually try and fight your natural biases, fears and greed.