Process and Spot

I heard Rory McIlroy being interviewed recently and when he was asked about the secret to his success, he answered that he focuses on two things: “process and spot.”

He focuses on the process of making the right swing with long and chip shots and focuses on hitting the right spots on the green with his putting.  Process and spot.

Great trading isn't much different.

Great trading is about following a proven process that, over time, puts you in trades that allow you to consistently make money. Great golf is about following a proven process for swinging the golf club that puts a golfer in position to consistently putt for birdies.

A great investment process puts you in position to trade ideas with attractive risk to reward characteristics. In trading, hitting the right spots on the green means trading ALPINE and ABYSS lines consistently.

The Process

Given that we are entering the dog days of summer and there will be less and less happening in global markets, I thought it would be a good time to dedicate this spaceof the report to the concept of building an investment process. Over the course of the summer, I will round out the conversation by covering the 5 critical components of an investment process geared towards earning superior investment returns:

Focus Markets – define your universe of investment instruments.

Market Bias – define your process for determining your opinion on each of your Focus Markets.

Actionable Price Targets – define how you will determine entry and exit prices for each trade idea you execute.

Position Sizing – define how you much capital you will invest in each trade idea.

Execute, Monitor and Close the Trade Idea – define what circumstances will cause you to close a trade idea that is currently open.

One of the core principles of my investment process comes from my medical studies: the concept of “the minimum effective dose.”  This concept comes from pharmacology and represents the least amount of a particular drug that is required to produce the desired response in the subjects taking it. 

I'm constantly applying this concept to my trading and I encourage you to apply this concept to your own investment process.  Improve the efficiency and the effectiveness of your process by eliminating all of the unnecessary actions that don’t improve the profitability of your process.

Refining The Process

This principle is best shown by walking you through step 1 of the investment process, defining your universe of investment instruments by determining the least number of markets that an investor has to monitor and trade in order to still have the opportunity for superior returns.

I define a “market” as any stock, mutual fund, exchange traded fund (ETF), currency or futures contract that can be traded in an ordinary brokerage account.

In The Whaley Report, I call these the Focus Markets and they're at the core of my investment process. Morningstar tracks 28,315 mutual funds and 625 closed-end funds.  ETF Database.com tracks 1,500 exchange traded funds.  In addition, there are more than 63,000 publicly traded companies globally and 15,000 of those companies trade in the U.S. both on exchanges as well as over the counter.  Not to mention the forex (currency) and derivatives markets.

So, your golfing buddies, your financial advisor, and the human resource person who helps with your 401k plan are all telling you to do different things with your money and you still need to decide which of the 93,440 investment options are right for you.

It’s enough to make a grown man or woman cry…or at the very least curl up in the fetal position when the spouse and kids aren’t around.

The Spot

I would eliminate mutual funds and closed-end funds (CEFs) from consideration but if you're going to consider them as part of your own Focus Markets, here are a couple of points to keep in mind.

First, both mutual funds and closed-end funds have much higher internal fees than their ETF (or stock) counterparts.  Another problem with mutual funds is that they can only be traded at the close each day, which creates a lot of unnecessary price risk. 

Closed-end funds (CEFs) carry a similar price risk because they rarely trade at a price that's equal to their NAV.  CEFs can be priced with huge premiums or discounts irrespective of how the underlying assets are performing.  Again, an unnecessary price risk and I'm a stickler for getting the right price.

I would also eliminate derivatives and forex markets from consideration for the simple fact that it takes specialized knowledge to play in that sand box and brokerage firms won’t let you trade in these markets without an acknowledgment from you that you have such knowledge. 

There are plenty of other financial instruments available to trade, making these markets unnecessary. This leaves us with exchange-traded funds (ETFs) and individual stocks.

You should have a thorough fundamental research process for understanding companies in order to mitigate the idiosyncratic risk that comes with holding individual stocks.  Walking through such a process is an entirely different report all together. 

If you don’t have a background in financial statement analysis or a process for understanding the operations and risks of individual companies, I would eliminate them from consideration as part of your Focus Markets. If, however, you are a competent “stock analyst,” feel free to include them as part of the process to determine which markets to trade—everything I say is as applicable to individual stocks as it is to my preferred instrument, exchange traded funds (ETFs).

Pick Your Spot

I prefer ETFs for an investor’s Focus Markets for a several reasons.  ETFs generally have low internal fees which have a negligible impact on overall performance.  ETFs trade during normal trading hours like individual stocks and very rarely trade at a premium or discount to NAV, which greatly reduces the risk of not getting the price you want. 

Finally, you can access a plethora of markets through ETFs, everything from global equities to currencies and commodities. The next time there is a slow week in the markets, I am going to use ETFs to walk you through the rest of the Focus Market process, however, this process for determining your investment universe will work with any financial instrument that trades on an exchange.