The selection conundrum

I am sure you have heard this often enough. The right path is the tough path to take. The road is strewn with difficulties. The wrong path is the easier path to take. However, though the wrong path seems easier, as you travel down that road, it can lead to ruin. The right path on the other hand, though the more difficult one, leads to your personal growth and happiness.

Isn't it nice to read? A nice easy way to determine what is the right decision to make? The unsaid assumption in the earlier statements is that if you keep choosing the more difficult options, you would be choosing correctly. The problem in this assumption is this. While all right paths might be difficult, all difficult paths are not necessarily the right paths. So while exercising regularly is both difficult and right, running away from home to become an actor is difficult but not necessarily right! Therefore using difficulty as a criteria for choosing between paths is therefore not necessarily the optimum solution.

The parallel in the world of investing can be seen very often. Specially in the world of advisors, sellers of infallible methods and ..... daily note writers! For eg look at the attached chart of S&P. It is made to look like a simple trendline break would have ensured huge profits over the last 12 years. Similarly, one can show that 80% of the trend reversals are accompanied by a positive or negative RSI divergence. Thus either trendlines or RSI divergences can be made to look like the Holy Grail of trading/investing.

The reason however, that things are not as simple as they seem is because while 80% of the reversals are accompanied by divergence in RSI, 80% of the divergences do not necessarily lead to reversals. Divergences occur more often than just at reversals. Mathematically it can be put as P(Div/Reversal) (probability of divergence given that there is a reversal) is 0.8 but P(Reversal/Div) is not 0.8.... it can be much lesser. And, really we are not interested in P(div/reversal), we are interested in P(Reversal/div).

This same inaccuracy can be seen in most methodologies that are touted including so called Candlestick Reversal Patterns like Hammer or Hanging Man. Lest you think that I am only going after technical analysis, the same problem is seen in fundamental analysis. It can be shown that before a large move a lot of stocks were available at low Price to Historical Earnings. Therefore low P/E can be touted as a method to buy stocks. The problem with that is the same as the one with technical indicators and patterns. While, given that there is a large move one can see that stocks had low P/Es, not necessarily all low P/E stocks made large moves. Therefore using P/E as a criteria for picking stocks need not be useful.

Saying all this has resulted in one understanding. In the world of trading and investment at least there are lots of easy paths out there like looking for divergences or trendline breaks or low P/E stocks or any such simple one size fits all kind of solutions. The more difficult path and perhaps the right one would involve lots more work and analysis to determine stock selection and direction. So in this world at least, perhaps, the more difficult path is the right one!

Having used up a lot of your time, I have to state that I remain out of the market. I will buy nifty above 5203 and will sell short below 5090.