How to enhance your chances of making money after May 16

Any investor, or trader for that matter, must have clear answers to a few questions.

1) Is the investor oriented to risk-reduction or return maximisation?

2) How does he/she define risk? Is he more averse to high short-term volatility or to prospects of permanent loss?

3) How disciplined is he? Will he pass up attractive opportunities, and be prepared to book losses, if that is what the methods dictate?

4) What does he do in circumstances when he thinks the market is mispricing?

Every individual has subjective answers to these questions and the answers will not only reflect temperament, they will define trading style.

Taking question 1, a risk-averse individual will trade less often and will tend to avoid stocks about which he is fundamentally ignorant. He will buy and hold fundamentally sound stocks. His downside risk will be low. A maximiser will enter stocks, which seem most likely to generate high returns fast. He will be less concerned about high valuations and may not even know what the business is.

As for question 2, defining risk is, in itself, difficult. Most formulae use volatility, or variability of returns, as a proxy of risk. The popular Sharpe Ratio for example, assumes standard deviation as risk proxy. But is volatility really a synonym for risk? It is perhaps, for a leveraged trader, holding time-bound assets such as futures contracts. But a long-term player, who is not leveraged, can wait for volatility to settle down, provided he is not holding over-valued stocks. Can he ignore capital depreciation in the portfolio if it is likely to be temporary?

As to question 3, there's an opportunity cost to being disciplined. If a trader uses a rigidly-defined system with mechanically calculated stop losses, is he disciplined enough to book losses when the system signals exits? If not, he risks even larger losses. If an investor uses value-investing methods, does he ignore over-valued stocks even if they are high-growth and likely multi-baggers? If an investor decides to only enter businesses he understands personally, can he ignore high growth areas requiring specialised knowledge? Warren Buffett for example, missed out on the IT, internet and biotech bull runs because he doesn't understand technology and he is disciplined.

As to question 4, the market can remain irrational for longer than any given investor can stay solvent. How much risk is an investor prepared to take, and for how long will he take that risk, in cases of mispricing? If he buys undervalued stocks, how long will he hold and what does he do if the price falls more? If he shorts overvalued stocks, and they move up, what will he do?

There are no hard-and-fast answers. But the questions are worth considering in detail. The stock market is on the edge of either euphoria, or collapse. A month from now, once election results are out, prices could move with dizzying rapidity. But we don't know the direction. If you answer these questions now, to your own personal satisfaction, your chances of making money after May 16 will be seriously enhanced.

The author is a technical and equity analyst