Stock Investing

Well, W.D. Gann is maybe a person you heard about the first time. I have “discovered” him only a short time ago. It’s strange that he is not so often talked about like Kostolany, Warren Buffet or Darvas. Why “strange” you may ask.

This man apparently had the ability to predict the stock market or commodity prices. He was so sure of himself that he once said something similar to this: “If wheat will not hit 1.20$ today then my whole system is wrong.” I’m not quite sure if it was wheat, but at that day it didn’t look like wheat would ever hit this mark. Surprisingly, it did! At that day wheat exactly closed at the price he had foreseen. After this, he became famous.

In a short period of time he turned a small amount of money into millions of dollars. His view was that everything is in order and connected. He believed in God and this also had a big relation to his investing and trading decisions. Gann had the view that numbers play a big role in predicting stock or commodity prices.

The problem with Gann is that his teachings are not easy to understand and thus most of the traders and investors trying to apply his knowledge fail to make profits in the capital markets.

I once came across an author of an e-book who claimed having found a way to exactly predict stock prices. I guess he employs Gann’s techniques. But I cannot tell you if the system worked, because he offers his e-book for a measly 5000$!!!.

There are rumors of Gann having lost almost everything at the end of his last days. How true that is, I don’t know, but it would be consistent with Gann’s view of all things: Everything is in order, thus what goes up must come down.

Stock Investing

Warren Buffet is one of the few who can be described as the father of stock investing. The term stock investing is generally aimed at buying and holding a stock for a longer term. This is exactly what Warren Buffet has specialized in. The question is if he made any profits by doing it. Maybe this information would be enough: He is the second-richest man in the world (ranked by Forbes).

What is his stock investing secret?

Warren concentrates only on companies whose business model he understands. That is one of his main principles. That’s why he kept his hands off internet or biotech stocks even then when these stocks were extremely en vogue in 1998 and 1999. This strict adherence spared him the notorious burst of the internet bubble in 2000.

And this leads to another stock investing principle applied by Mr. Buffet. Whenever he has found a stock (or company) to buy he tries to wait for an adequate time to enter. And this is generally when stocks go down. He knows why this happens. Not because stocks have become worse than a few days ago. It’s because fear rules those times. But when the market fears Warren stays calm and goes “shopping”. He discovers great bargains and cannot resist not buying these undervalued stocks.

What we have learned from him is this: He never looks to the chart pattern of a stock, he puts great emphasize on the intrinsic value of the stock or company. The intrinsic value describes what a company’s real value is or in other words what somebody would pay for a company if it wouldn’t be listed on the stock market.

Other things Warren Buffet used for his stock investing:

- detailed due diligence of every stock you want to invest in because the investor should always treat stocks as a part of a company (and that’s what it is), thus, who wants to buy a junky company?
- Debt level should be low or better not existent at all
- Return on Equity (ROE)should not diverge, be above the industry average and over 12%
- Unimitable competency over competition (brand name, technology, pioneer)
- Using earnings for further growth
- Rising earnings with over the average margins

So what are the stocks Buffet bought and never sold? Everyone knows them. Stocks like Coca Cola, Gillette or General Electric.
Buffet even has his own stock or company, it’s Berkshire Hathaway. But its more a Holding, where he holds the stocks of great value. With this stock he gave ordinary people the opportunity to make a fortune from scratch.

Stock Investing

As the word “trading” indicates swing trading is actually not stock investing. Stock Investing is always aimed at holding something for a longer term.

Swing trading has the purpose to buy a stock and hold it for only one to four days. Thus, it is very short term orientated. Even in a stable trend a stock is always in motion not only in one direction. Within an upward trend short termed downward movements are not rareness. The same is valid for a downward trend pattern. Here a trader can make use of rapid rising stock prices.

Generally, for swing trading bar charts are used. These bar charts however are slightly changed in so far that 4 different occasions can be differentiated and given different colors (colors can change):

Green: Current high is higher and low is higher than the day before.
Red: Current high is lower and low is lower than the day before.
Black: Current high is lower and low is higher than the day before.
Blue: Current high is higher and low is lower than the day before.

After this the points have to be marked where

- an up day is followed by a down day and
- a down day is followed by an up day.

The criterion for being a down or up day is not the closing price but the highest or lowest point of that day. So a green chart doesn’t always need to be followed by a red chart only, it could also be a black chart. This is possible, because the black chart doesn’t make a higher high.
These points describe a change in a trend. Whenever a down day is followed by an up day the trader should enter the position and immediately set his stop at the previous days’ low.

The same is valid for the other case with the difference of not buying but short selling.

If stock investing is too boring for you maybe swing trading could be an adequate substitute.

Stock Investing

What is a momentum stock? It is a stock that gains momentum or begins to rise stronger than before. These are the stocks which make such tremendous moves like 100% -1000% per year. Yes, these kinds of stocks are rare but they are still there. Stock Investing based on momentum stocks could be very lucrative but it has also its risks.

The risk is that stocks of this kind tend to drop much stronger than non-momentum stocks. It’s clear: what goes up must come down. And the higher you are the deeper your fall will be. Keep this in mind. This is a general stock investing rule.

Together with the sharp rise in price you can generally see a common thing. A rising price is mostly accompanied by a rising volume or a higher than average volume. If this happens this is a good sign for the stock to become a momentum stock.

An increase in volume indicates that more stock investors or traders get to know about this stock. The stock gains higher popularity and the word about it is faster spread around. Thus, more buyers jump on the bandwagon. After this the stock has already gained let’s say 80%, but now it can take off and go to about 150-300% or more.

You must bear in mind that momentum stocks are mostly low capitalization stocks of much under 1 billion $. Boarding the train in time that means before it already has taken off is difficult. But seeing a train already moving is possible.

What you must do is to find stocks that have the characteristics mentioned above: rising price and volume. These are generally also stocks which have hit their all-time-high, but that is not necessarily like this.

When you buy such a stock then please pay attention to the stop loss you set. You must set it immediately after your purchase; otherwise the sharp drop could kill you.

As you can see momentum stocks are a great alternative stock investing strategy with high risk and high return.

Stock Investing

Today I want to talk about a very interesting topic. It’s about Neural Networks used to facilitate stock investing decisions.

Generally, you have a lot of neurons, which build the neural network, in your body. What I am talking about is the artificial neural network. Artificial in so far in that it is made up by bits and bytes. Therefore, it is a software which gets impulses and sends responses.

The basic structure is exactly the same like the one you learned in school. You have an input, then one or several hidden layers and the output.


The hidden layer is the part of the system where the computing is taking place. The computing formulas are put in upfront. But it can only compute what it is given. Thus, the “feed” is very important for getting good results. If good stock investing is the goal then only related and relevant data is needed. Just like in real life, “you can only reap what you sow”.

And just like in real life you earn when you learn. The neural network will only give satisfying results if it gets enough input. After a certain time the neural network will give certain units within the hidden layer more weight and others lesser. The unit-weights are fractions of 100%.

The tester or stock investor must be careful and know when to stop the learning process. Otherwise an overlearning could occur. This means that after having reached the best results with the neural network in terms of delivering adequate stock investing recommendations the output quality sinks. Therefore, the recommendations become worse.

Stock Investing

Now that you know how to use the CAPM for stock investing matters it’s time to be more critical in terms of how useful the CAPM is for practical applications.

First of all, let’s have a closer look at the assumptions that the CAPM sets:

1. Investors behave rational and risk-averse.
2. Everybody has perfect information ( = everyone is like an insider!)
3. Borrowing or lending is always possible at the riskfree interest rate
4. No transaction costs.

Now decide for yourself. Do you really think that investors always behave rational and risk-averse? Think about booming and crashing days, this is probably not the case.

What about perfect information? Yeah, that would be really great, isn’t it? To know everything about every company, that would give you a clear advantage for your stock investing! No, it wouldn’t, because the assumption is that everybody knows it J

As you can see, the assumptions are really unrealistic, but nevertheless shall we use it for stock investing decisions?
Well, a bigger problem is this:

The CAPM uses the risk factor “beta”. Do you know where this info comes from? It comes from historical data. And these are assumed to continue in the future. But risk factors can change anytime. Moreover, the market return is also just expected, not guaranteed!
The security line of the CAPM tries to explain return subject to the risk it carries.
So, the more risk you take on, the more return you can expect. Well, if stock investing would be so easy…

But this risk-return-relationship is not always linear, it’s much more complex. Another problem is that a stock’s expected return is solely dependent on the market return. We all know that there are much more influencing factors for a stock’s price than only its portfolio.

A bunch of other problems exist with this methodology, but I think it’s enough to know that for stock investing purposes this model is a bit too simplified. In spite of this, I would recommend you to explore this for yourself. The more you explore the more you discover!

Stock Investing

In the last article I introduced the CAPM as a stock investing decision tool.
This time I want to apply this to a certain example.

However, before beginning with it, I want to make the equation of the CAPM clearer.
Here it is again:

E(Ri) = Rz + [E(Rm) – Rz]Bi

Can you remember the math lessons in high school?
You have definitely heard something about linear equations of the type:

y = 3x + 4

The CAPM-equation is exactly the same. The linear equation here in the example begins at 4, the CAPM at Rz. The gradient is 3 and the gradient of the CAPM is E(Rm)-Rz. The resulting linear line is called the security market line.

The recommended decision of the CAPM is this:
Buy those stocks which have an expected return above the return the CAPM calculated for this certain stock.

It must be more precise thus, you get an example now:

Stock a
E(a) : 20% (expected return per year)
Beta(a) : 1,3

Stock B
E(b): 15%
Beta(b): 0.8

Stock C
E(c): 22%
Beta(c): 2,5

The expected market portfolio should be E(Rm) = 12%
The riskless security Rz = 3%

Using these information with the CAPM brings these results about:

E(a) = 3% + (12%-3%)1,3
= 3% + 9*1,3
= 14,7%

This means for stock a: The real market value of stock a is 14,7%, but 20% are expected, thus stock a is a definite “buy”.

E(b) = 10,2%
15% are expected, so stock b is also a “buy”.

E(c) = 25%
But only 22% are expected, thus stock c is not a “buy”, it is a “sell”.

If you don’t have any expected information about stocks, you can also compute how much return a certain stock must bring in when the expected return of the market portfolio and the beta of the stock you are focusing on are known.

Stock D

Beta = 2,3

E(d) = 23,7% can be expected.

Ok, I hope you know what the CAPM is trying to teach us and how to apply it. It’s in principle very simple. Yes, but is it also practicable concerning real stock investing?

This question will be discussed in the next issue.

Stock Investing