Forget ‘Buy Low and Sell High,’ and More Wisdom from William J. O’Neil

William J. O’Neil is well-known as the founder of Investors Business Daily and the author of the book called, “How to Make Money in Stocks: A Winning System in Good Times and Bad.” The book sets forth his investment methodology called CANSLIM. CANSLIM is primarily a momentum- and trend-following approach that considers both fundamentals and technical conditions.

O’Neil’s investment system was a major step in the evolution of trend following and built on the work of Jesse Livermore, who is considered by some as the greatest trader ever. Nicolas Darvis’ “box” system was outlined in his book, “How I Made $2,000,000 in the Stock Market.”

O’Neil’s methodology is one of the better approaches to the market for individual investors. It doesn’t bother with issues like the Modern Portfolio Theory or asset allocation. It is a stock-picking system that is highly reactive to overall market conditions.

I’ve incorporated a number of elements of O’Neil’s market philosophy into my own trading. The two primary concepts that I embrace are.

First, forget prediction and focus on reacting to market conditions. In the IBD market-timing system, O’Neil does not change his market outlook until there is an actual change in price action. There is no attempt at calling tops or bottoms. Tops require distribution days and other technical factors. Bottoms require strong moves on good volume and follow-through.

Second, O’Neill is not a purely technical trader. His system considers fundamentals and looks for strong revenue and earnings per share growth. But he defers to pricing action: No matter how strong a stock’s fundamentals might be, he doesn’t want to own it if the price action is weak.

Here are some quotes from O’Neil that provide further insight into his market approach, followed by my commentary:

The first thing I learned about how to get superior performance is not to buy stocks that are near their lows, but to buy stocks that are coming out of broad bases and beginning to make new highs … … It is one of the great paradoxes of the stock market that what seems too high usually goes higher and what seems too low usually goes lower.

New investors almost always gravitate toward the idea of “buy low and sell high.” It seems very logical and is an obvious way to make money. But “buying low” is much harder than it sounds. We can only recognize a low in retrospect.

The best moves in a stock usually come as the crowd of investors slowly start to understand why a stock is showing relative strength and that momentum can carry a stock much further than anything else.

My philosophy is that all stocks are bad. There are no good stocks unless they go up in price. If they go down instead, you have to cut your losses fast. Letting losses run is the most serious mistake made by most investors.

One of the easiest mistakes to make is to become emotionally attached to a stock and to find ways to hold it even when it is acting poorly. The discipline to cut laggards quickly has more impact on returns than anything else.

When you appear to be right, always follow up… Investors cash in small, easy-to-take profits and hold their losers. This tactic is exactly the opposite of the correct investment procedure. Investors will sell a stock with a profit before they sell one with a loss… The whole secret to winning big in the stock market is not to be right all the time, but to lose the least amount possible when you’re wrong.

George Soros has expressed a similar philosophy. It is not whether you are right or wrong. It is how much money you make when you are right and how much you lose when you are wrong.

Over-diversification is a hedge for ignorance.

O’Neil emphasizes homework. Know what you own and why and have a plan for trading it. If you are disciplined in handling your trades, then you can be much more concentrated in the stocks that have the best prospects.

I’ve never met a successful pessimist.

A positive mindset is the key to great trading. That doesn’t mean being a perma-bull. It means always being confident that if you stick with your methodology, there will always be great opportunities. It may take some patience at times, but the market will always reward those who keep slogging away.

Many market participants are struggling with this terrible market, which makes it a particularly good time to consider the wisdom of William J O’Neil and incorporate it into your trading and investing.