This is a guest post by Jeremy McNeil, owner and blogger behind RoboticInvesting.com (subscription service is currently available free of charge). In this article, he will detail his method of momentum investing.
I am going to show you the exact investment process I have used to grow my retirement investment account to six-figures. This strategy is not a secret. It is not a black box strategy that you need millions (or even thousands) to use.
It is a strategy that many knowledgeable investors use to trade with the market rather than against it. Simply put, it looks for stocks in a solid long term uptrend. But more on that a bit later.
Let me tell you how I got to this point because I am sure many of you do-it-yourself investors will be able to relate to the problems I am up against.
I am 40 years old and I am trying to grow my portfolio as fast as I possibly can so I can quit my job and live off of the income from that portfolio. Based on my calculations I am going to need $2 million in investment assets to be able to generate the $80,000 per year (assuming a 4% withdrawal rate) my wife and I will need to retire and live a rich life.
To get there I need to add $1.2 million to my portfolio by the time I am 60 years old. I could do that by saving $5,000 per month (20 years = 240 months X $5000 = $1.2m). But as you’ll see in a second, that ain’t gonna happen right now!
The other way I can do that is work on making sure I get the best return I possibly can on my money. In other words, making sure I am putting my existing portfolio to work properly, protecting my capital, and maximizing gains.
But there are a number of problems in my way. Let me describe some of them to you; see if any of these relate to where you are with your investment portfolio.
Problem #1 (Big Expenses Coming)
I have two awesome kids. They are also super expensive, and it is getting worse as they get older. Never mind the “normal” stuff like clothes, food (my 14 year old son spends 80% of his day when he is at home with his butt sticking out of the fridge), sports (competitive cheerleading = money pit), and just life in general. The big cost is going to be post-secondary education.
For my son, that is only four years away.
The average cost of post-secondary education is $24,000 where I live – and that is just tuition. Add books and living expenses and the number skyrockets.
Given that I have two kids, double that. Granted, mom and dad aren’t going to pay for it all. They are going to need to work and come up with some of the money on their own, but my wife and I have decided to help them get a jump start on life so we are going to fund a good part of their school.
Based on my calculations, I am going to need approximately $80,000 to $100,000 to put them both through some sort of post secondary education. This is going to have an impact on the amount of money I have available for retirement.
Problem #2 (I Can’t Possibly Save Enough)
I am fortunate enough to earn a decent salary. However, much of that salary goes to paying for life. Things I talked about before; clothes, food, sports. After everything is paid for each month, there is not a lot of discretionary income left over to invest with.
I do manage to save approximately 15% of my income and invest that, but it is not going to be enough. In fact, based on my income there is no way I am going to be able to save $5,000 per month.
I am not going to be able to simply “save” my way out of this problem, no matter how frugal we get.
Problem #3 (Mainstream Investing Fails)
I have been able to fight off the big mainstream investment brainwashing out there about the pros of investing in mutual funds. That was easy (from the 2014 SPIVA U.S. Scorecard):
“Based on data as of Dec. 31, 2014, 86.44% of large-cap fund managers underperformed the benchmark over a one-year period. This figure is equally unfavorable when viewed over longer-term investment horizons. Over 5- and 10-year periods, respectively, 88.65% and 82.07% of large-cap managers failed to deliver incremental returns over the benchmark.”
The trouble is getting away from the “index investing is the be-all and end-all of investing methodologies”. It is compelling: super diversified, low fees, and most importantly you were going to get exactly what the market was going to give you. By going with index funds I was “assured” that I was going to get good returns.
However, with index funds, what no one told me was that you only get what the market gives you – no higher, no lower. That can mean low returns AND there long periods when index investing doesn’t recover from big drops.
As I explained, I am not going to be able to “save” myself out of this. I cannot put enough money into my account every month to save the required amount of money. I need to rely on maximizing the growth of my portfolio through returns while also preserving capital.
That is spectacular given that the average stock inflation adjusted annualized rate of return is “only” between 6 and 7%.
However if we take a longer view the picture is not as positive. Over the past 10-years the S&P 500 has returned 5.26%, which means that the same $100,000 would be worth $166,968. That is a big difference and is below the average inflation adjusted return is somewhere between six and seven percent.
Although 5.26% is better than nothing (or a loss), I need more if I am going to achieve my retirement goals.
There have been people who have achieve returns greater than the market. For example, Tranquility Trading has seen annual returns of 18.4% in 2014 and 20.9% in 2013. Mulvaney Capital Management saw a 67.36% return in 2014. Those are the type of returns I need if I am going to be successful. It can be done with the right tools.
Along with the risk of low returns with an index-only strategy, there is a second risk and that is the risk of index “suckage” (ok, not a technical term but it works!).
I want to reiterate that I still believe index funds should make up a portion of my portfolio. Diversification of strategies in a portfolio is important; going all in with one style is risky. So I still do have index funds + my systematic investment style which I will get into.
The other sub-problem I had with mainstream investing is the risk of long periods of index “suckage”.
Have a look at this chart of the Nasdaq:
What do you see? What I see is a very long period of time for the Nasdaq to recover from the crash in February 2000. Index investors who held through this had to wait until November 2014 to get back to even.
I have 15-20 years until I am going to want to retire (but hell I’ll do it earlier if I can!). If I have to wait for 14 years for a recovery from an index that stays down that will destroy my chances of a good retirement.
Want another example? Although it is not as extreme, the S&P 500 has had long periods of getting back to even. Check out this chart which shows you what I mean:
Index investors who bought at the peaks have had to wait for years to get back to even. I understand that most investors like us dollar cost average into investments. However, with that strategy the time to recover from long draw downs and buying on the way down still takes years.
So, as a 40-year old do-it-yourself investor I was really worried about not being able to meet my financial goals because I risked periods of low returns AND long periods of down markets I sought out better ways of investing.
The problem was those “better “ ways of investing also didn’t work for me. Day trading and swing trading seemed like the holy grail, but I failed.
Problem #4 (I Can’t Predict The Future)
I am a failed day trader and swing trader. In fact, I suck at all kinds of discretionary trading. A discretionary investor decides to buy investments based on subjective criteria. For example, they base their investment decisions on fundamentals like dividend growth or earnings per share. They may also based it off of chart patterns.
When it comes to picking stocks based on things like fundamental analysis or reading charts, I am terrible at it. The root of the problem is that I really suck at predicting the future.
However, I believed that I would be different than everyone else who failed at day trading and swing trading; I believed I was smart enough to make it work.
I signed up for different day trading and swing trading sites to watch the gurus in action so that I could learn. I read as much material as I could find. I studied chart after chart and pattern after pattern to try to identify which stocks to play.
But I could never make it work. I would either try to follow the trade announcements that were happening in the chatrooms, but my entries would always be too late to actually see a profit. Even if I did manage to make a profit it was never enough money to move the needle.
Then I realized that following on-line gurus was silly. In day trading, the entry is crucial and between the time it took the announcer to announce the trade too many seconds passed by and I missed the big move. What about trying it myself?
I tried gaps, moving average crossovers, fibonacci retracements, cup with handles, etc. to try to move in and out of my own ideas. Some worked. Most didn’t and I was bleeding money.
As a family man with a mortgage, two kids, and a wife I couldn’t take the risk so I threw in the towel.
Day trading and swing trading didn’t work for me because at the end of the day, day trading and swing trading is super hard and still relies on the trend of the market to get it right. Some people, like me, are just not cut out for it and will actually never be able to last long enough in the game to get good.
Plus I was not about to drop $2,000+ on trading DVDs that were supposed to teach me the “secrets” to day trading or swing trading. Don’t forget that those online gurus can make a lot of money selling the dream of huge profits through day trading. I bet they earn more from DVDs that actual trading.
So what is a failed and dejected day trader supposed to do? Go quietly back to their corner and build a portfolio of index funds and be content with just being average? I think I already covered why that doesn’t always work.
But I still didn’t want to give up on the dream of being rich based off of my investments?
Continued research led me to what people call systematic investing or mechanical investing. These tools provide a way of increasing my returns to that I can retire and be sure to have enough to get my kids through school.
Use Facts to Select Stocks That Are Trending Higher, Not Predictions!
Systematic trading does not try to predict the future. Instead, it takes irrefutable facts that are happening with the markets and individual stocks and makes decisions based on those facts.
It is very different than the discretionary investment choice you may be used to. With discretionary trading, the investors results relies on their skill when making investment decisions. It relies on their interpretation of things like EPS growth and what that will do in the future, gross margins, and revenue growth. It relies and is impacted hugely by human emotion.
Systematic trading on the other hand uses computer models and statistical analysis to decide what to invest in. It bases its investment decision on the mathematical facts and determines the best course of action.
My style of systematic trading involves trading based on trends and momentum with clear buy and sell signals. I am going to show you how I get “systematic” with my investing and stop guessing which stocks to buy. Instead, I let the market and some very specific, well tested, well researched, and proven methods to pick the top stocks to buy.
This is different than fundamental investing – fundamental investing is trying to predict the future based on ambiguous data (EPS, revenue growth, etc) that may or may not continue to exist. It is buying on the hope that those fundamentals will continue in the future and drive the share prices higher.
Instead, I now read what the trend of the market and stocks are and make decisions based on that data rather than predicting where EPS is going to go for the company and deciding to buy based on “potential” future EPS growth.
The one “hard” piece of data that has been a strong predictor is the trend of the stocks. A stock going up tends to continue going up. A stock heading down, tends to continue going down. Have a look at this chart for Electronic Arts Inc. (EA) and the up trend since 2014:
The process I use is all about finding stocks like this that are going up, buying when certain rules are met, and buying in a risk-managed systematic basis. That will give you more success than buying an index fund on the premise that the market always goes up. Yes, it always goes up, but we never know when, for how long,
There are always stocks that still go up when the market is down – that is the power of trends. And you can find these trends by reacting to data and using systematic investing strategies to determine when to buy them.
This is going to help you take the emotion out of investing and generate buy and sell signals based on clear facts like is the market in a bull or bear market, has the stock been trending high for the past 90 days, and is it trending better than 499 of the other stocks in the S&P 500.
This process is going to let you ride these stocks as they are rising and get out when they are heading down, or the market is in the toilet. Unlike index funds you are not going to simply wade along taking only what the market give you. With systematic investing you are going to ride the waves up, and not invest when it is dropping. Those two concepts combined will increase your returns AND protect your capital.
As a 30 to 55 year old investor, those are going to have huge benefits.
How to Buy Stocks that Move Higher – React to the Data
The key to building a return-producing portfolio is using tested and proven strategies that give you an edge. These are not intended to just meet the market returns – anyone can do that – just go buy the index funds and be content that you will get what the market gives you up and down.
These systematic trend following strategies go for additional return by buying the best moving stocks in the past 90 days and riding the trend.
If you think that buying based on trend and momentum is something you want to implement in your portfolio you have a couple of options.
The first option is to identify an experienced practitioner in this area. I have been investing based on a trend and momentum system for some time, and have an updated and thoroughly back tested system that I personally use and offer to other investors as a service. Using AmiBroker and a subscription to a data feed provider that ensures I get accurate data to run my screens, I can be sure I am getting the stock picks I should be getting. In addition, it takes a fraction of the time as the software can process thousands of stocks for trends and buying opportunities. That is what I do and share with subscribers at my site and blog RoboticInvesting.com (currently free to join!)
The backtested results have been solid. I have been able to generate 3.5 times the market returns in backtested results and have generated average backtested returns of 19% since 2005. There is a lot more detail on the site, but that is the highlights.
The second option is to do it yourself. This takes a lot more work, a lot more time, and you must be sure you are using accurate data. Crappy data in = crappy data out. This method can work but is not truly systematic as you need to manually search for the stocks and determine which 15 – 20 are the best options.
That said, the methodology to find potential stocks is similar. Use a tool to identify stocks in an uptrend, determine how much of those stocks to buy based on position management, and then sell based on specific rules. Let’s discuss how to do that.
Step 1: Determine a Market Direction Filter
Trading using a trend and momentum following system, especially one that is long only and based on equities, is WAY easier if you trade in the direction of the market. An easy way to do this is to set up a market direction filter that tells you when to buy and when not to buy.
I personally use a moving average on the S&P 500 as my indicator here. If the S&P 500 is trading above its 200 day moving average then I buy stocks from the screen. If it is below then I don’t add any new positions.
This does not mean I sell anything; I determine that later. It only means that I am going to sit on the sidelines while the market doesn’t behave nicely.
Step 2: Identify Stocks in an Uptrend Using Finviz
This sounds easier than it is, but you want to seek out stocks that have been in a consistent uptrend you can do this in a couple of ways.
One way to search for stocks in an uptrend is to use software packages like TC2000 or AmiBroker. However, if you don’t have access to these packages and you want to find trending stocks then Finviz is one nice free option.
To do that, go to the screener section of Finviz and setup the screener with the following options. This will give you a starting point for stocks to continue looking at.
Ideally you will want to have a way to rank all of the stocks that come up. Without being able to do that with software you can look for the stocks in the longest and most pronounced uptrends.
As a good rule of thumb, I would also suggest that you avoid stocks that have had any gap ups or downs in the past 90 days. Stocks that have gapped have a lot of volatility and since this is a longer term strategy, that is not the volatility we are looking for.
Once you have done that you might come across examples like DHI. As of this writing, DHI actually comes up on my own strategy software. Look for 15 – 20 stocks like this.
With that list of stocks, it is now time to calculate how much of each stock you are going to buy.
Step 3: Determine Position Size for Your Chosen Stocks
This step is even more important than the stocks you identify in Step 2. Optimal position sizes can reduce your risk substantially. Most retail investors usually take the amount of capital they have to deploy, determine how many stocks they want to buy, and then put an equal amount into those stocks. That is not how professional investors do it.
Position sizing is the step in your trading strategy that tells you how much money to place into a given trade. By doing this you are limiting the downside risk one stock can have on your portfolio.
There are many ways to manage positions sizing. The one I personally us is the one I learned about from Andreas Clenow in his book “Stocks on the Move”. In his strategy he uses a stock’s Average True Range (ATR) to determine how much to put into a stocks. If you have not read his book, then I highly suggest you do so as it is an amazing education in trading stocks that have good upward movement.
ATR is a metric that tell you how much a stock moves in a given day. It his calculated over a set period of time; usually 14 days but you can use whatever you want. For example, if a stock has an ATR(14) of $0.99 that means that on an average day in the last 14 days the stock has moved $0.99. For this example we are going to use the ATR(20) to give us the average range over the past 20 days.
The best place I have found to get the ATR(20) is on Stockcharts.com. I add an indicator to the chart and can instantly see the ATR(20) for any stocks. Here is what that looks like for DHI which has a 20 day ATR of 0.943.
Here is the method in a nutshell. The formula you are going to use to determine how much to put in a stock is as follows:
# of Shares = Account Value * 0.001/ATR(20)
The 0.001, or 1.0%, is the amount of risk you are allocating to each position. The impact of each position on the portfolio will be 0.1%. This is how you manage the risk in your portfolio.
So to determine how much you should put into each position you will take the amount of capital you have to invest in the strategy, multiply that by 0.001, and then divide by the 20 day ATR. This will tell you exactly how many shares of that stock to buy.
You work your way down for each stock in your list, using the formula above, until you run out of cash in your portfolio. You will be left with a portfolio of stocks, purchased in the right amount of stock considering how much that stock moves and how much you want each position to impact your portfolio.
Most investors don’t go this extra mile and pay the price for it. Treat your trading like a business and put proper position sizing into your process and you will be better for it.
Step 4: Rebalance Portfolio Once Per Week
Once per week you need to go through Step 2 again to see which new stocks may be added to the list of stocks Finviz identifies as trending stocks. You also need to check the current status of the stocks you purchased already.
When to Sell
If any of the stocks you currently hold have dropped below their 200 day moving average then sell. These stocks are no longer trending so you should reallocate your money to better momentum stocks.
If any of the stocks have had a big gap up or down in the past week (like around 15%), then sell. Gappers have shown huge volatility which means more risk so in the interest of capital preservation the recommendation is to sell if that happens.
Check Market Direction
Remember that you are not buying any stocks if the market is not trending too. So, go back to Step 1 and determine the market direction. If the S&P500 is above its 200 day moving average then the market is still trending up and a safer environment to open new positions. If it is now below its 200 day moving average the market is not trending higher and not worth taking the risk of opening new positions.
Buy New Positions
If after that you have cash to invest, then look for those new stocks on your list and buy them based on the process in Step 3.
I don’t personally think the market is going to get any easier in the next few years. In fact I believe we are in for some huge volatility. However, I really have no idea and I am done trying to predict where the market is going.
I have huge costs coming up including sending my kids to school and financing a retirement for my wife and I. To get there I need to invest in a way that protects my capital while gives me returns that are better than the market.
By using a process that systematically selects trending stocks and buys them based on an easy to use market timing method and most importantly position sizing principles, I have a way to protect my capital while giving me access to high probability setups.
As a supplement to a standard index investing approach, it can expose you to high probability setups that generate the excess returns you are looking for.
Jeremy McNeil is the trader responsible for Robotic Investing. At the site he shares his process for selecting and investing in trend following and momentum based high probability setups. The subscription service is 100% free of charge for a limited time.
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