The Strategy

Introduction

Before we get to the nitty-gritty, we need to get one thing straight: this is not a get rich quick scheme (“YOU can make TEN MILLION DOLLARS from only FIVE THOUSAND in TWO MONTHS!”). So if you’re looking to take your lunch money and pump it into ten million bucks in a couple months, I can’t help you. Well, actually, it’s a good bet that probably no one can.

I’m also not going to claim I’ve come up with the be-all and end-all trading strategy. Many trading strategies will make money over time, but only if they’re applied with mechanical consistency, which is difficult because it’s hard to keep our emotions (greed and fear, mainly) out of our trading habits. Most of these strategies also involve setting stop losses, which are in essence fail-safe sell or cover points to help control losses if a trade goes against you. Unfortunately, they won’t protect you from the worst potential losses, which are price gaps between the close of one trading day and the open of the next. If a stock gaps against you on bad news, for example, you can take a real beating when your stop gets triggered at the opening price.

Price Gaps on Daily Chart

Price Gaps on Daily Chart

Setting the gap issue aside, using stop losses can help preserve your capital over the long run. But you have to understand that every conventional trading strategy out there involves taking losses – oftentimes many of them – which are then hopefully offset by periodic big wins, or in some cases a lot of small wins. The hard part is having the intestinal fortitude to absorb those losses and keep trading through the gut-wrenching fear as your capital is being eroded away.

The truth of it is that most trading strategies are little more than educated guesses based on a variety of indicators that the market will go a certain way, with the trader placing bets against the house (“Mr. Market”) every time he trades. NO ONE knows with certainty which way the market is going to go, and I’ve seen, and been in, trades where every indicator pointed one way and the stock did just the opposite.

Oh, just so you know: stock analysts and fund managers don’t know any more than you do about which way the market is going to go. If you look at the performance records of market analysts calling a buy, sell, or hold for a stock, you’ll see that they’re wrong at least half the time. As for fund managers, most of their funds don’t do any better than the indexes – and many do worse – so you lose money to the market while also paying stiff fees to the managers. That’s how they make their money. Ouch.

These traditional technical strategies are what I used for a few years when I first began “playing the market.” I tried just about every trading methodology out there, and while I had quite a few wins, the losses – which were, ironically, driven mostly by the fear of losing money or stop losses that were tripped – destroyed nearly half of my capital before I figured out what the heck I was doing. Now, granted, I wasn’t playing with really big bucks (which is probably a good thing), but no matter how big or small your portfolio is, having half of it vanish before your very eyes is never a fun thing to watch.

Automatic Investment Management: AIM

This is when I stumbled upon the core element that I now use in my trading  – or, more accurately, my investing – strategy: How to Make $1,000,000 in the Stock Market Automatically by Robert Lichello.

Yes, I know exactly what you’re thinking! Something like “Oh, what a crock of poo!” is probably running through your head. It’s a horribly ridiculous title that no doubt has sent many a trader and investor away laughing without ever touching the book.

But the concept that Lichello developed, which he called Automatic Investment Management, or AIM, is sheer genius: AIM is a purely mathematical approach to managing how much you buy or sell of a security or an entire portfolio at any given price. It doesn’t rely on indicators of any kind, but uses elementary school level math to grow your money.

Lichello originally intended AIM to control an entire portfolio of stocks (or, alternatively, a single mutual fund). While you can certainly do that, my own system has several AIM “machines” or calculators in a set of spreadsheet tabs, one for each of the stocks in my portfolio. After the initial setup, you just plug in the current price of each security and AIM will tell you how much to buy, sell, or hold. Needless to say, I highly recommend you check out Lichello’s book.

Beyond the emotionless mathematical simplicity of AIM is a completely different philosophy than you’ll see with most trading systems: it wants you to buy shares as the price drops, then sell as the price goes up. Not all at once in either direction, but the greater the move, the more you buy/sell. Buy low, sell high, right? Accumulate shares as they get cheaper, then sell them off at a big fat profit as the price goes back up. That’s what the “smart money,” the big institutions, do. The “dumb money,” the retail investors like you and me, tend to do the opposite. How many times have you heard things like, “This stock is in a strong uptrend and has reached an all time high – the time to buy is now!” Then you buy in and – surprise! – the stock price takes a nosedive shortly thereafter. In a panic, you finally sell after taking a huge loss, only to scream bloody murder as the price then begins to climb again. Rinse, wash, repeat, and your hard-earned money vanishes right before your eyes. If you always seem to find yourself on the wrong side of a trade, you have lots of company: Wall Street makes its money by taking it from people just like you. Every trade has a winner and a loser: AIM will finally put you on the winning side.

Once you understand how AIM works, your mindset will flip around. While others panic when a stock price takes a nosedive, you actually begin to look forward to it! Why? Because you know AIM is going to tell you to scoop up a bunch of bargain basement shares as the price plummets. You want to buy stock at a discount; it’s the exact same principle as waiting for something you want at a store to go on sale. You don’t go in and buy something that’s marked up, do you? No, you go in when it’s marked down. You don’t want to buy at 150%, you want to buy at 50%…or lower. The very same thing applies to stock purchases.

One thing that may come as a shock is that, using the AIM system, you never use protective stops. Ever. You don’t need them or want them. And that eliminates worries about market manipulation, where the market makers send a stock’s price plummeting to take out protective stops so they can scoop up shares at a discount before driving the price higher again, screwing us retail investors in the process.

“But wait,” you say, “what about risk management? How do I protect my capital?” The first part of this answer is that AIM does much of it for you. As a stock’s price rises, AIM will be selling off shares. During the euphoric furor when foolish retail investors are pouring money into a stock, driving the price ever higher, AIM will be selling shares like mad. And after the price peaks and starts down on the bobsled ride from hell to the bargain basement, most of your position will be safely in cash, ready to scoop up heavily discounted shares sold by loss-stricken retail investors who bought in near the top.

Your cash reserve for a given stock or mutual fund will only start drying up as price hits rock-bottom prices and AIM is trying to scoop up as many shares as it can in anticipation of the next cycle of rising prices.

Beyond AIM’s internal risk management function, I also manage risk by position size. While you could easily use AIM to control a single mutual fund or a portfolio of stocks (which is how Lichello intended it to be used), I apply it individually to each stock in my portfolio. Since any given company could – potentially – go bankrupt or have the price of its stock crash, I allocate no more than 5% of my total portfolio to any given position. So, even if a company went bankrupt and the stock value went to zero, my risk for each stock is contained.

Now it’s time to take a look at how AIM works