By: Alon Horesh
– 3-minute read
– Note: This is part-two of our two-part series on the importance of having an investment strategy.
Photo credit: Quora.com
In part-one of our series, I defined an investment strategy and explained how a few can generate alpha. I also broke down why having an investment strategy is so important. In part-two, I explain how a professional trader selects an investment strategy and break down the difference between fundamental and technical analysis strategies.
Let’s get started!
How A Professional Trader Selects An Investment Strategy
On Wall Street, winning investment strategies start at the ground-level. First, a portfolio manager outlines a clear objective: What is my desired return? How do I achieve it and take the least amount of risk? Then, he takes a systematic approach to achieving the objective. And what’s involved? Vast amounts of historical data and rigorous back-testing.
Back-testing an investment strategy allows you to see how the strategy performs in bull markets, bear markets, crashes and when the market is non-trending. It prepares you for every possible outcome. The results also produce statistical probabilities that outline your risk and return expectations. Remember, profitable investment strategies look to achieve the highest possible Sharpe Ratio. When accomplished, you end up with a safe investment that outperforms the market on a risk-adjusted basis.
Now, many individual investors can perform the above analysis from home.
But, what separates the average trader from a professional trader?
Access to technology.
On Wall Street, technology is king. Professional traders use advance algorithms to analyze hundreds of variables at once and obtain investment recommendations in a fraction of a second. Whether its abnormal volume, support/resistance breaches or golden cross/death cross, algorithms detect precise entry and exit points faster than humanly possible.
When you follow the investment advice of a professional trader, you can produce the same results.
Technical vs. Fundamental Investment Strategies
To predict long-term trends, fundamentals are king. Earnings. Cash flow. Macroeconomic variables. They play a key role in determining the long-term direction of the stock market.
But, to predict short-term trends, a portfolio manager relies on technical analysis. When you analyze price, volume, momentum and investor sentiment, you can predict where the market is headed over the next few hours, days or weeks. For example, momentum trading systems allow you to take advantage of market euphoria. When the bulls are loose, buyers continue to place bids at higher and higher prices. When you follow the investment advice of a professional trader, you learn how to ride the wave and capitalize on the uptrend.
A similar approach is volatility breakout. When the market moves – either up or down – a certain percentage from a given price-level, odds are the trend will continue for a certain length of time. By rigorously back-testing the strategy, you can break down the odds to a statistical probability – and predict the most efficient entry and exit points. Most importantly, this is when algorithms earn their stripes. An investment strategy is useless if it lags the market. But, when you already have an algorithm in place, you can increase or unwind positons without even blinking.
Remember, winning investment strategies take time and dedication to perfect. So, don’t settle for less.