We probably all heard the old adage: Location, Location, Location. It’s considered the number one rule in real estate investing. For stock investors there is a similar rule: Observation, Observation, Observation. Sounds simple, but what does it mean?
As an investor or trader I may be using fundamental analysis, I may be using technical indicators, or cycles.. I may be watching the daily news or scanning social media for good stock tips. But all these tools will not be of great help unless I can bring it all together with proper observation. And observation is more than just watching or reading.
First of all, proper observation requires a certain distance. Imagine you are in the middle of a crowded square. From that position it will be very difficult to have a good overview of what is going on. Then you go to the 10th floor of a nearby building. Suddenly you have a very good overview of the entire square and all the movement. And then you go the 80th floor of the building. You can still see the square, but now you are too far away to spot any details. So, there is an optimum distance if we want to observe a square and all its activities.
A similar detached observation is needed when I try to watch the stock markets. Watching from the right distance I can see what is going on out there without being swept away by the frequent waves of emotion that keep rolling through the participating crowd.
Secondly, I should not only observe the markets in a detached way, I also need to observe myself. Am I tired? Am I happy? Do I feel depressed? Am I greedy? Or angry? Do I want to take revenge for a previous loss? Did somebody’s comment on a social network upset me?… All these different moods can and will affect my ability to observe the market in a neutral detached way. If I am not aware of my mood I will start making bad trading decisions.
Having a lot of money at stake will also influence my observation skill. Being long or short in the market may cloud my vision and I will start tending to see the glass as half full or half empty, depending on my positions in the market.
So, we already found two types of observation: observation of the market, which we could call “the outer game”; and observation of myself, which is “the inner game”. Honing my skills in both departments can help me to become a better investor, but what is the third observation?
Well, the third is “observation of my observing itself”. That may sound mystical, theoretical or excessive, but it really isn’t. Observing the markets and observing myself is all nice and good, but if I don’t observe my methods and ways of observing then I will never really sharpen my observation knives. This third observation is neither outer nor inner, it encompasses both.
Now we have three forms of observation. And all three require the necessary distance. Distance from the market, distance from myself, and distance from my own observing.
Each form of observation will generally improve with practice, but they have to be improved more or less simultaneously if we want to improve beyond a certain level. E.g. We can use the internet to read and absorb the observations that other traders are making. But just like we don’t grow muscles by watching somebody else lift weights, reading about other people’s observations and trades is not going to help much when it comes to improving our own skills.
A little metaphor may help to dig this. Reportedly there was once a man who read every book he could find about swimming. Then he went into the water and drowned. That may sound funny, but it keeps happening every day in the stock market waters. The reason is that reading books and courses and websites about investing typically fills the reader’s head with a bunch of concepts that mainly belong to the “outer game”, and if they are very lucky there is one chapter about observation of self. But having some logical concepts in our head is still miles away from practical observing in real time in the real world. So, what to do?
The best advice that can be given to a new trader is: start by putting one foot in the water. Because most new investors cannot wait and jump in right away, excited by the prospect of easy profits without working. Some make it back to the shore before drowning in the stock market waters, and others don’t.
The second best advice that can be given to a new trader is: don’t listen too much to the other swimmers and go at your own pace. It feels so scary alone in the water and herd instincts tend to take over when people are in fear, so most are soon following somebody who reportedly won a medal at the olympics years ago. A little later they find themselves in deep open water, the nearest shore out of reach, and the master swimmer they trusted and followed waving back at them from the beach bar with an expensive drink in hand. If they are lucky the coastal guard rescues them before the sharks appear. Yes friends, the stocks markets are shark infested waters, and everything you read is fishy.
Of course, this metaphor was just a long way of saying that there is no good substitute for doing your own thinking and for doing your own trading based on your own observation. And that observation doesn’t have to be limited to the stock markets. At some point you may discover that even observing and talking with drunk people in a pub is useful practice for an investor. Why? Because there are always a lot of intoxicated people in the market. People who are intoxicated with emotion from recent losses or recent profits… People who are intoxicated with the latest central bank guidance, or with the most recent quarterly filings of Carl Icahn. People who are intoxicated with lunar cycles, or with my reversal levels… All these things can make an investor drunk with expectation and hope, unless they are being watched from the necessary distance. If you can detect which side of the market is more intoxicated then you have found an edge. The intoxicated side is usually louder and has no doubts that they will be proven right, so they can be easy to spot.
This gives just a few examples of what may happen along the path of observation. Eventually you may watch a leaf fall from a tree and deep down it will resonate with your understanding about the markets. Then you have become a true market observer.