the Contrarian Stock Trader

Investment Strategies

Benoit Mandelbrot, the famous mathematician and inventor of fractal
geometry, has forever changed the way we understand many natural
phenomena and influenced a host of modern fields from chaos theory to the
financial markets.

Before Mandelbrot, the modern theory of finance used in most existing
investment models, was based on the following shaky assumptions:

- People make rational assumptions. When given all the relevant
information about an investment, individual investors will make the obvious
rational choice leading to the greatest wealth. Thus the sum total of all
investor's actions will result in an efficient market, with all of their rational
actions driving prices quickly to their "correct" level. Rational investors make
for a rational market.

In Reality, people are hardly ever rational and self-interested. Behavioral
economics show how people misinterpret in formation, how emotions of fear
and greed distort their decisions, and how they miscalculate probabilities of
reward, risk and ruin.

- All Investors are alike. People have the same investment goals and hold
their investments for the same periods. With the same information, they will
make identical decisions. Thus a model that describes one investor describes
them all.

In Reality, people are not alike. Some buy and hold stocks for a long time,
others day trade. Some look for stocks in fundamentally solid companies that
are going through a correction; others try to get on board rapidly rising
stocks. Without homogeneity, the mathematical models of the market
become very complicated. The market changes from a well- behaved system,
with predictable outcome, to a chaotic one with unanticipated results.

- Price Change is more or less continuous. Stock prices always move
smoothly from one value to the next i.e. the market is subject to the natural
law of inertia and, once in motion at a certain speed, will tend to continue to
move at that speed.

In Reality, this smooth stock movement is interrupted by sudden jumps all the
time. Discontinuity is an integral ingredient of the markets and cannot be
ignored.

- Each price change is independent from the last and the process
generating these price changes stays the same over time. Also, price
changes follow the bell curve with mostly small changes and extremely few
large ones.

In Reality, life is more complex and markets do have a memory, i.e. what
happens now will be reflected in behavior far into the future.

Based on chaos theory and fractal geometry, Mandelbrot describes the
characteristics of the markets as follows:

1. Markets are Turbulent

Their behavior can be compared to the behavior of flowing fluids when
reaching certain speeds. When a liquid or gas runs slowly through a tube, the
flow is nice and smooth. This kind of flow is called laminar. As the flow
accelerates, here and there it breaks into sharp and intermittent eddies;
these eddies produce yet more, smaller eddies and a cascade of whirlpools,
from great to small , appears. This is turbulent flow. The suddenly smooth
flow returns momentarily. Then more turbulence followed by smooth flow. The
same kind of turbulence happens in the financial markets with abrupt lurches
between mild motion and quiet activity, discontinuities, and concentrations of
major events in time.

2. Markets are very Risky

Turbulence is dangerous. Its output can swing wildly and suddenly. It is hard
to predict, harder to protect against, and hardest of all to profit from.

3. Market Timing is very Important

Big gains and losses occur into small packages of time. Concentration of
major events, and volatility, is common.

4. Prices often leap, not glide

That financial prices often jump, skip and leap up or down adds to the
investment risk.

5. In Markets, Time is flexible

The same risk factors apply to a day as to a year, an hour as to a month.
Only the magnitude differs, not the proportions. That 's why charts with
different time scales look the same. Statistically speaking, the risk of a day is
much like that of a week, a month or a year. Only the price variations, and
thus the magnitude of potential wins or losses, scale with time.

6.Markets in all Places and Ages work alike

One of the surprising conclusions of fractal market analysis is the similarity of
variables from one type of market to another. Also, the patterns, in space or
time, remain the same even as the scale of observation changes. Finding
market properties that remain constant over time and place means you can
make better, more useful models and make sounder financial decisions.

7. The Distribution of Price Changes Scales

The proportion of big changes to small changes in a financial price series
follows a consistent pattern. This results in wilder price swings than you
might otherwise expect. Scaling means that the odds that a massive price
movement will follow a large one are the same as merely a sizable one
following large movement.

8. Markets are Deceptive

The long-range dependence in prices creates a tendency in the data-not
towards any particular price level, but towards price ranges of a particular
size or direction. The change may be persistent and reinforce each other, i.e.
a trend once started tends to continue,or the trend once started may
reverse. Persistent trends appear to display long, slow, up-down cycles of
three.

9. Volatility clusters

Large price changes tend to be followed by more large changes up or down,
and small changes by more small changes up o or down.

10. In Financial Markets, the Idea of "Value" is useless

What is the value of a company, and how does this number correlate with
the price of its shares? There seems to be no correlation, no matter how you
define this value. For example, the most common index for market value is
the price-earnings ratio, or P/E. Taking Cisco Systems as an example. At its
peak during the Internet bubble, its forward looking P/E reached a value of
137. If this was the actual intrinsic value, you have had to assume that
earnings would keep up its torrid pace for at least another decade. At this
point Cisco's market value would have been more than the annual production
of the entire U.S. economy! After the bubble burst, Cisco's P/E fell to 26,
even though its earnings growth was actually faster than during the bubble
days.

CONCLUSIONS

How do we thrive in such an existentialist world? People make money in the
markets all the time. Based on the new chaotic, fractal model of the markets,
here follow the most important ideas to adhere to when investing in the
financial markets:

What really counts are price differences

not value or price. The only thing to keep in mind is that, to make money,
your selling price has to be higher than your buying price and, obviously, the
greater the difference in these two prices, the bigger your profit. Thus the
general idea that you should "buy low and sell high" is really misleading since
it entices investor to waste a lot of time finding low priced stocks with a
potential of moving higher. Any stock, at any price, has the potential to
move up or down! Thus the stock price is not a criterion in trade selection.

A Trend once started tends to keep going

There is a long-range dependence in price changes of a particular size and
direction. The changes can be persistent and thus reinforce each other. In
this case a started trend will keep on going. Thus an investor should look for
strong trends with large price changes.

Reversals can happen any time

Sometime the price changes are anti-persistent and a trend in one direction
may reverse itself. Also, any trend will eventually come to an end. Such
events are not predictable and an investor should confirm that the stock he
wants to buy is still moving in the right direction prior to pulling the trigger,
and, once in the market, always use stops.

The "Buy and Hold" Strategy is Dangerous

Many financial advisers and stock brokers always seem optimistic about the
stock market and promote the buy and hold system whereby you buy a
stock- usually on their recommendation- and hold it for many years. Since
the risk is independent of the time scale, i.e. long-term investing is just as
risky as short-term investing, but the magnitude of potential losses scales
with time, the risk of ruin with a long-term commitment is much greater than
with a short-term exposure to the market. Lots of people lost a lot of money
when their "long-term investment" turned sour when the Dot.com bubble
burst! I know people, planning to retire early based on their huge gains during
the bubble, who now believe they will never able to retire because they lost
all their investments during the subsequent crash.

Putting it all together

To make money in the stock market, buy (or short sell) stocks in a strong
trend with a strong momentum (a stock with big price changes in one
direction). Place a tight stop to minimize a potential loss and continuously
adjust your stop to protect your gains. Get out at the first reversal. This
method will give you a good chance for profit with the least exposure to the
market and thus minimum risk .

Since the markets are inherently risky, it is prudent to only use less than
50% of your discretionary money for stock market investing.