Circle of Competence

Most of the top investors subscribe in one way or the other to the Charlie Munger concept of investing in stocks that one can understand. Of course, its quite another thing that most of us have literally no clue regarding how a company makes profits (other than that its products are popular and hence its making profits).

Lets take a simple Example. Bata India. Its the largest shoe company in India and at one time or the other, most of us would have bought for our-self or for family a shoe or a slipper from a Bata Store. But is the business really simple to understand. I doubt that most investors can really understand a company enough to risk serious money on the company (or any company for that matter).

I am more of a subscribe to Technical Analysis as a much simpler and better way to place our bets (we are after all, knowingly or un-knowingly betting on certain outcomes) but even here, I wonder how many a trader really digs deep enough.

Lets take a simple RSI for instance. Since it comes installed as a default indicator in most technical analysis software, most traders who use charts would have encountered the same in one way or the other. But how many really understand how the RSI is calculate, how many understand why the default number is 14, how many understand what a divergence in RSI and Price is really showcasing, how many know why 30 and 70 are seen as barriers (at least in the default version).

The other day, a friend of mine looking at a chart of Nifty with Stoch said that markets are overbought and shall fall. Of course, he is falling into the classic trap of mistaking overbought as a signal to sell. But I would not blame him since he is least bothered with what the indicator is all about as long as it provides a signal or a view to support his bias.

While reading a article today, I learnt that 42% of Americans do not read another book after they have completed their studies. With a average life expectancy of 78 years and assuming one finishes his education by the year 22 / 23, that is really a long period of no structured learning.

In the markets, it does not matter what approach you choose as long you are willing to learn everything and anything that concerns it. So, if Trend following is your poison of choice, learn all about the strategy, learn and understand what are the risks in using that strategy, what are the limitations of using trend following strategy in stocks vs using them on Indices and finally what is the reward for pursuing the strategy.

As Henry Ford says,

Anyone who stops learning is old, whether at twenty or eighty. Anyone who keeps learning stays young.

Learning about your system will help you in times when the seas are rough and the mind says that the best way forward is to abandon the ship. It can be a tremendous moral booster when the ride turns rough since once you understand the nature of your system and the reason for its current volatility, you will be much more prepared to take the next trade rather than worrying whether it makes sense to abandon the strategy in favor of another that is seeming to have succeeded during these tough times.

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About Prashanth

Have been a full time participant in the stock markets since 1996. Run a Yahoo Group where focus is exclusively on discussions of the Indian Markets using Technical Analysis as the tool (groups.yahoo.com/group/technical-investor)
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