The Concept of Synergy
Synergy is defined as the mutually cooperating action of separate substances that together produce an effect greater than that of any component taken alone. The combined effect is greater than the sum of the two pars taken separately.
In spite of all the research that takes place regarding the movement of stock prices, in spite of all the data available to investors, and in spite of all the charts produced by all the computers traders use, the simple fact remains that there are no “perfect” stock market indicator-d probably not even any near-perfect indicators. Every so often, some indicator becomes popular, usually after only two or three successful predictions. For example, based on a just a few major market cycles that took place after World War II, it was assumed that bear markets “must” take place when dividend yields for stocks decline to below 3% or when price/eamings ratio: rise to 21 or 22. These parameters, which indicated the bear markets of 1966, 1969 and 1970, for example, were again approached during the mid-1990s. However, the time around, the Standard & Poor’s 500 Index did not see its bull market end until the year 2000, by which time its price/eamings ratio had risen to 46 and its dividens yield had declined to just a touch above 1%.
In any event, even if a perfect indicator were discovered, sooner or later its com ponents would become known, with its effectiveness dissipating as investors begar to follow it en masse. (Where would the sellers come from if every investor became a simultaneous buyer?) The simple fact is that, at best, market forecasting is a matter not of perfection, but of probabilities. A realistic set of goals is to be right more often than wrong, to develop the emotional willingness and technical ability to recognize quickly when we are wrong and to take appropriate action, even if that means accepting a stock market loss. (Generally, the best losses in the stock marke are the losses quickly taken.)
Successful investors are not in the stock market at all times. They assess the probabilities of success as carefully as possible and take positions only when the odds an in their favor. One way to improve the odds is to employ the concept of synergy: The likelihood of a successful trade improves considerably if there are multiple indica tions in favor of the stock market action you are contemplating.
How do synergistic indicators compound the favorable probabilities? Well suppose that there are a number of uncorrelated stock market indicators, each of which tends to be correct 60% of the time and incorrect 40% of the time. That probably about as good a batting average as you are likely to see in a stock mar ket timing indicator. (The indicators should be dissimilar to each other in their construction and concept. Otherwise, they might, in reality, simply be the Sam indicator in disguise.)
You normally trade on one indicator that produces a buy signal, which opt to follow. The probabilities of a successful trade are GOo/-actually, pretty decent for stock market trade, particularly if you have an effective exit strategy.
Instead, you change your strategy and begin to maintain two unrelated market indicators, each of which has a 60% success rate. You initiate a plan by which you will take positions only when both indicators produce confirming signals to support your contemplated market action. What effect is this likely to have on the odds of successful trade? The probability of a profitable trade rises from 60% to 84%. If you maintained three indicators, each of which has a 60% accuracy rate, takin positions only when all three suggest similar action, the odds of a successful trad rise even more, this time to 93.6%.
It follows, then, that you should make serious attempts to confirm buy signals with multiple indicators whenever possible and to look for confirming as well as non confirming indications before taking positions. I shall be emphasizing this concept as we move along.