George Soros is a trading legend. And, he is an investment legend because he achieved amazing results.

Over more than 40 years, George Soros delivered an average annual return of about 20% to the investors in his hedge fund. At that rate of return, a $10,000 investment when the fund was started in 1969 would have grown to more than $20 million when Soros closed the fund in 2011.

Source: Harald Dettenborn Wikimedia Commons

The most famous story of Soros’ success might be the day that he broke the Bank of England and reaped a one day profit of more than $1 billion. Trades like that have led many individual investors to believe that Soros traded markets they cannot or choose not to access.

However, Soros started his career as a stock market analyst and wrote about his stock market investments in his 1987 book The Alchemy of Finance. In the book, he noted that his stock selection was responsible for most of the returns in his hedge fund.

A Roadmap To Success

The book is a kind of diary of the fund’s progress over a period of about a year. During that time, the value of the fund more than doubled.

In addition to recording his thoughts on the market, Soros shared details of his investment philosophy in The Alchemy of Finance. He wrote, “Most of what I know is in the book…I have not kept anything deliberately hidden.”  This makes the book a must read for serious investors.

Among his important insights into investing is the idea that the thought processes of investors are often just as important to the movements of economies and markets as more “objective” factors such as interest rates and measures of economic growth.

This led him to the conclusion, according to The Telegraph, Soros believes that “anyone who tries to predict the markets by assuming that they behave rationally is doomed to failure.

He said his concepts “provided me with a new way of looking at financial markets, a better way than the prevailing theory. This gave me an edge, first as a securities analyst and then as a hedge fund manager.”

This indicates that sentiment indicators can be as important to understand as fundamentals. “Many investors make a distinction between market sentiment and business “fundamentals”, implying that anyone who can ignore the former and concentrate on the latter is likely to make better returns.

But Soros pointed out that there were two problems with this attitude. First, anyone’s knowledge of the “fundamentals” of today’s highly complex markets is bound to be incomplete. But, Soros realized that investor sentiment didn’t affect just share prices, it could actually change economic fundamentals.”

Economics Confirms the Theory

Economists label this idea the wealth effect, which is the concept that change in spending that accompanies a change in perceived wealth. Usually the wealth effect is positive: spending changes in the same direction as perceived wealth. The wealth effect can be significant and is seen around the world.

Source: Federal Reserve

From Soros’ perspective, this means that “Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. A boom-bust process is set in motion when a trend and a misconception positively reinforce each other.”

He said the simplest example was a property boom. Here, the trend is the availability of cheap credit; the misconception is that property is worth more for other reasons and not just because more people are able to buy. That is confirmed by the Fed data shown above.

News Can Create Opportunities

Although his theory is important, Soros will always be best known for his bet against the Bank of England in 1992 in the run-up to Britain’s eviction from the European Exchange Rate Mechanism, the precursor of the euro. This was his billion dollar day.

The Exchange Rate Mechanism was meant to keep European Union (EU) currencies in rough alignment until the euro was introduced. This meant that when, for example, the French franc rose against the dollar, the Bank of England tried to ensure that the pound did too.

Soros believed that this was an unstable situation and he believed that based on the fundamentals the pound was becoming overvalued. That hurt British exporter and was unsustainable in the long run as political pressure would mount along with exporters’ pain.

Another problem was that interest rates needed to be increased to maintain the artificially inflated value of the pound. That slow hurt the economy and added political pressure to the central bank and other policy makers.

Soros understood that at some point the pain would be too much for the government and Bank of England would be forced to devalue the pound. This insight led him to take a short position in the pound that would benefit from the decline when it occurred.

On a day that would become known as “Black Wednesday,” Soros’ bet paid off. The Bank of England cut interest rates, the value of the pound fell sharply and Soros collected his profit.

Since that time, he has made other big bets in currency markets and captured large gains in trades on the Japanese yen and in other markets.

This is, of course, different from buy and hold investing. Soros looks for quick gains and the chance to find additional quick gains. He takes profits and prepares for the next trade rather than holding to achieve a long term gain for tax reasons or other purposes.

Individuals could apply this philosophy to the stock market. They know that large moves can follow earnings announcements and identifying extremes in sentiment could provide opportunities to benefit from reactions after earnings are released.

Exchange traded funds also allow individuals to access currency markets and commodities without accepting the risks of futures contracts. That could make it possible to benefit from moves in oil or gold as Soros has in the past.

In fact, Soros did use the SPDR Gold ETF (NYSE:GLD) for a recent trade in that market. The key is to look for sentiment and then identify the trade. That could help investors enjoy profits like Soros.

His recent holdings indicate a bearish outlook for the broad stock market but a favorable view of broadcasters.

Source: WhaleWisdom.com

Individuals could consider put options. Like Soros, or they could consider specific stocks or sectors he finds attractive. History does say that Soros is likely to be profitable in the long run.

Ichimoku Cloud charts are a popular tool for analysts, perhaps because they are visually appealing.

The most prominent feature on the chart is the shaded areas. These are the Clouds. There are actually five components of the chart and the construction of the Cloud Chart can be summarized as follows:

1. Turning Line, which is the midpoint of the high and low of the last 9 sessions.
2. Standard Line which is the midpoint of the high and low of the last 26 sessions.
3. Cloud Span A is the midpoint of the turning line and the standard line and is shifted forward by 26 bars.
4. Cloud Span B is the midpoint of the high and low of last 52 sessions and is also shifted 26 bars forward.
5. The Lagging Line is the price line the (the closing price) shifted backwards by 26 bars.

Each of these components is also known by other names. The Turning Line is called the Tenkan-sen or the Conversion Line in some sources. The Standard Line is the Kijun-sen or Base Line. The Lagging Line is also known as the Chikou Span or the Lagging Span.

Now let’s look at how to analyze the chart of Apple (Nasdaq: AAPL) shown above. It can be confusing to look at the chart because there are several pieces of information. With experience, many traders like having a large amount of information available at a single glance.

With less experience, the chart can be overwhelming. To cut through potential confusion, we will look at that chart in three steps. In the first step, we will look only at the clouds and then we will address the interpretation of the various lines.

Because the chart is less confusing, we have compressed the time to show more signals. With just the Clouds, interpretation is easy. When prices are above the Cloud, the chart is bullish. When prices are below the Cloud, the chart is bearish.

When prices are in the cloud, the answer is not clear but we should expect the previous trend to resume. Right now, prices entered the Cloud from above so we should expect AAPL to resume its uptrend.

The chart above shows these signals are clear enough that they can be traded. Sell when prices fall below the lower span of the loud and buy when prices break above the upper line of the Cloud. This is similar to a trading strategy using moving averages (MAs).

One problem with any MA is that signals come after the trend has reversed and you need to capture long-term trends to make up for the delays in the signals. Another problem with MAs is that there will inevitably be a number of whipsaw trades.

A whipsaw trade is one that lasts a short time before being reversed. These trades usually result in small gains or losses but trading costs can add up. These costs are generally overcome with an MA strategy because you will eventually be on the right side of a long-term trend.

Clouds should also deliver profits from long term trends but they will suffer from lags in signals and whipsaw trades while waiting for the big winners that are generally needed to make a trend following system successful.

This is an important point. Any individual trading decision based on Clouds can be wrong. There could be several losing signals in a row. It generally requires discipline to take 100% of the signals and a long-term commitment to profit from Clouds or any trend-following strategy.

In the chart above, we see that AAPL dropped below the lower line of the Cloud in the middle of November. This is bearish and it will take a break above the upper line of the Cloud for AAPL to turn bullish with this indicator.

The next chart removes the Cloud Spans and includes only the Turning Line and the Signal Line.

These lines are moving averages and should be interpreted in the same way any MA would be interpreted. When the faster moving average is above the shorter average, the chart is bullish. In this case, that would mean the Turning Line is above the Standard Line.

When the shorter MA is below the longer MA, the chart is bearish. In the chart above, the Standard Line, the longer moving average that uses 26-bars instead of 9 in its calculation, is shown in red. In the chart above, when the red line is on top, the chart is bearish.

From the chart above, you can see this system does a nice job providing buy and sell signals. Right now, AAPL is bearish on this reading.

Many traders will prefer a simpler approach than Clouds. A simple MA system, maybe buying when the 50-day MA crosses above the 200-day MA and selling on a downside cross, could be easier to trade. There would be only one signal to watch in that system.

With Clouds, traders have three signals to watch:

1. Relationship of the closing price to the Cloud Spans; if the close is above the Clouds, the signal is bullish and when the close is below the Clouds the signal is bearish.
2. The position of the Turning Line to the Standard Line.; when the Turning Line is above the Standard Line, the signal is bullish and when the Turning Line is below the Standard Line the signal is bearish.
3. The position of the Lagging Line to the Cloud Spans; buy signals are given when the line is above the Cloud and a sell signal is given when the line is below the Cloud.

A trader could trade when all three signals agree or when two of the three agree or in some other way. You could also pick one of the three signals and base all decisions on that indicator, ignoring the other components of the Clouds.

The important point, as it is with any indicator, to apply the same rules consistently. If you are consistent and disciplined, Clouds could deliver gains in the long run.

While many investors spend a great deal of time considering what to buy, that may not be the most important decision for investors. The other decision investors might focus on is the decision related to when to sell. But, again, that might not be the most factor contributing to their long-term success.

According to the American Association of Individual Investors, in what the editors consider to be one of the most important articles they ever published,

“It is widely agreed that the asset allocation decision is the most important one an investor will make. How you split your investment funds among stocks, bonds and cash (that is, short-term debt) is more important than your choice of stock mutual funds.

Experts, not surprisingly, do not always agree on the precise allocations that different types of investors should adhere to.

Yet, in comparing recommendations from published advisory sources, it is clear that there exists a broad consensus about the appropriate mix among stocks, bonds and cash for most individuals during each stage of their life cycle.

Of course, all recommendations carry a disclaimer that individual circumstances may dictate a mix that is quite different.

Many individual investors, though, resemble at least roughly the “typical” investor profile.”

There are some specific guidelines that could help many investors improve their performance, according to the article. The general rules include:

• Choose a fixed weight strategy, with rebalancing at least annually.

Specific asset mixes will differ at different points in an investor’s life cycle. In order to maintain a given asset mix, the portfolio must be periodically rebalanced.

The simple idea is that a stable asset mix gives an investor a stable risk exposure that is appropriate for their financial needs, which are typically dictated by the stage in life.

A fixed weight strategy is a long run contrarian strategy. When stocks rise from being fairly valued to overvalued, the investor sells the overvalued stocks and buys bonds (or cash), or when putting new money into the portfolio purchases bonds or cash rather than stocks.

When stocks fall from being fairly valued to undervalued, the investor sells bonds and buys the undervalued stocks, or uses new money to buy stocks. In short, a fixed-weight strategy allows someone to profit from market misvaluations while maintaining a stable risk exposure.

• A portfolio’s risk can be moderated by mixing stocks and debt.

Stocks are claims against real assets. Bonds and cash are debt, usually promising fixed returns. Stock and debt are fundamentally different animals and, consequently, their returns tend not to follow similar patterns to each other. Consequently, combining stocks and debt moderates the portfolio’s risk.

On a broader scale, individuals who hold stocks and debt in their investment portfolio and own their own home have their broad portfolio diversified among stocks, debt and real estate—three asset types whose returns do not vary closely together.

• The longer the investment horizon, the larger the portion of the portfolio that should be allocated to stocks.

Young investors who are years from retirement can invest more of their portfolio in stocks than the elderly. Although year-to-year stock returns are volatile, the young can be reasonably confident that the good years will more than offset the bad years over their investment horizon.

 As you age and your investment horizon shortens, you are less confident that there will be enough good years to offset the bad, and the recommended allocation to stocks decreases.

• Everyone should have some exposure to stocks, even a conservative 80 year old couple.

Historically, the returns on a portfolio of long-term Treasury bonds have been more volatile (that is, riskier) than a portfolio with 90% bonds and 10% common stocks.

Stocks held alone are riskier than bonds held alone, but due to the magic of diversification you can add some stock to an all-bond portfolio and actually reduce the portfolio’s risk.

Diversification means not putting all your eggs in one basket even if the basket looks safe. Since 1926, the volatility of an 80% bond/20% stock portfolio has been equal to that of a 100% bond portfolio. This helps explain why no one recommends a stock weight of less than 20%.

• Diversify within the stock portion of the portfolio. In particular, an investor should always have an exposure to large-value and large-growth stocks.

There are two dimensions to investing in the stock market: size and style. Size refers to the size of the firm. In general, the 500 stocks comprising the S&P 500 are considered “large” stocks, which account for almost 75% of the market value of all U.S. stocks.

Style refers to the investment style or philosophy to which a company is most likely to appeal. Growth investors seek growth stocks—firms with fast-growing earnings. Value investors seek value stocks—firms whose shares are selling below their “real” value.

• International stocks should be a part of everyone’s portfolio, with the possible exception of the elderly.

Recommendations for international exposure start at about 15% to 20% for younger investors, and gradually decrease as one gets older. One source recommends no exposure for those who are 75 or older.

• Young investors should put more emphasis on international stocks, small stocks and growth stocks while older investors should put more emphasis on large-cap stocks, especially value stocks.

While broad diversification is always encouraged, younger investors can take more risk, and can therefore place greater emphasis on the riskier portions of the stock market; older investors can still invest in these areas, but their emphasis should be on more stable, large-capitalization companies.

• Investors can avoid the emerging international stock markets.

Emerging stock markets promise a wild and bumpy rise. The average Mexican stock lost 60% of its value in three months ending in March 1995. Of course, dramatic gains are also possible.

• As one ages, shift the bond portion of the portfolio from primarily long term bonds to primarily intermediate term or short term bonds.

Bond prices become more stable as maturity shortens. Thus, the advice to shorten bond maturity as one ages is consistent with the other advice to move toward assets with more stable prices.

• As one ages, the cash portion of the portfolio increases.

Increasing cash assets is part of shortening the bond maturity for increased price stability.

• High grade corporate bonds and Treasury bonds of similar maturity are close substitutes.

No one distinguishes between buying high-grade corporate bonds or Treasury bonds of similar maturity, because the returns on these bonds move very closely together, although high-grade corporate bonds tend to have slightly higher yields.

Over the long run, these rules have delivered strong returns.

Within the stock portion of the portfolio, stock selection can add significant value and a disciplined approach to stock selection can deliver large returns.