InvestorQ : Can I follow my trading strategies that have been successful in the past?
Juvina Maggie made post

Can I follow my trading strategies that have been successful in the past?

Sakshi Malhotra answered.
3 years ago

It is normal for most traders to focus on strategies that have worked. After all, a known devil is better than an unknown angel in most cases. But when you follow the strategies that worked in the past, there are some precautions you need to take. That is because, what worked in the past, need not necessarily work for you in the future also. Here are a few reasons why such a strategy may not really work for you again:

The successful strategies that you are tracking pertain to the past. While the past is a good guide to the future, the facts change with circumstances. As we have seen earlier, the past is not necessarily representative of the future. Just because a particular set of stocks have outperformed in the last 2 quarters, it does not mean that they will continue to outperform in the coming quarters too. This practice of extrapolating the past into the future is against the basic grain of investing and trading.

Never forget the issue of context of any trading strategy. Every strategy has a context and they tend to be successful because the context was favourable. Such contexts are caused by a set of circumstances and there is no guarantee that such a combination can sustain. Basing your entire investment or trading strategy on a fortuitous set of circumstances would be putting your capital to unnecessary risk based on something that is not scientifically proven. If the context has changed, you will end up losing money by just following a past strategy. That is not a very good idea in the first place.

There is also a very pragmatic side to this equation. The whole idea off a portfolio is that you are provided with an in-built mechanism of being liquid when markets are down and being invested when markets are moving up. By shifting your portfolio to chase your historical success, you will end up losing out on both these advantages. That is something to be cautious about. In the process you must not lose out on the core idea of making the best of the market movements.

While the strategy may have worked, the triggers may be different. A rate cut will work for rate sensitive stocks when these stocks are underpriced, not when they are awfully overvalued. Not all outperformance is due to fundamental factors. For example, we have seen sectors like banking and IT perform for a very long time just because there were institutional flows into these stocks. Here we are considering a time frame of just 2 quarters. Basing your future strategy based on the data from just 2 quarters may risk mistaking the noise for the trend. Blindly following a trend just because it was successful will not be too fruitful a strategy for you.

One of the basic assumptions of investing is that you diversify the risk of your portfolio. Over a period of time as portfolio concentration increases you keep re-allocating to other sectors waiting for the big move. When you tamper with the original assumption of diversification you are actually changing the entire risk-return profile of the portfolio. That will also mean increasing your required rate of return. That is not factored!

When you just follow a strategy that worked in the past, you run the risk of replicating a strategy and averaging your position. You are violating the cardinal rule of not averaging positions. You are applying the averaging rule in a reverse manner and the risk is that you could end up with an unfavourable price point. You lose your advantage. By averaging your position in the right strategy, you are falling victim to the popular fallacy that what was right will be right and all outperformance is sustainable. That is not necessarily true.