If market and stock indicators were always exact in identifying tops and bottoms, the necessity for prudent money management would not exist. Unfortunately indicators are anything but exact. Suppose for a moment that your indicators were correct – say – 99% of the time. The 1% failure rate could conceivably wipe out a trader or investor who did not apply some sort of money management technique. In my 40 years of market involvement I have personally been exposed to many indicators, I never have seen a market indicator even approaching that kind of preciseness, or anything even close to it.
Preservation of Capital, Steady, Consistent Performance, and the Pursuit of Enhanced Returns, are three simple principles that collectively act as a starting point for making profits in the marketplace. They are hierarchical. Utilizing preservation of capital will lead to steady, consistent performance and that makes the pursuit of enhanced returns possible.
Risk and Reward are probably the two most commonly used words on Wall Street. Risk is generally associated with losing capital, and Reward is generally associated with gaining capital. While these two associations are valid, they simply do not give enough information to utilize in our portfolio’s management.
But what is Risk? If you look at the similarities between the markets and a game of chance, you will note that both require skill and luck, but more skill than luck. Both require knowing how to manage money, so that even if you lose a few, you’ll still be around to play. And both involve exposure to the chance of losing money, which is the meaning of Risk.
There are generally 4 phases to the market and to individual stocks (not necessarily coinciding), that were first popularized by Stan Weinstein. Picture in your mind a bell curve, first a period of basing, or sideways price movement, followed by a period of prices trending higher, then a topping process, and finally a period of prices trending lower. Take for example the sell-off in 1929. It occurred after what was then the longest bull market in history, and after an unprecedented 11 primary up-swings. Similarly, preceding Black Monday (October 19,1987), the market was in its seventh leg and had appreciated 27% in just over 96 days. You must always be aware of where you are on the bell curve to properly analyze your risk at any point in time. Typically, at bull market tops, the whole world is long, but there is a lot of “scared money” in stocks. Consequently, the market is ripe for a panic sell-off with news that would otherwise not produce a large sell-off. It is our purpose here to help you in developing your plan and managing your risk.
Money and Risk Management
Approaching market participation with risk as your prime concern forces you to look at performance from an absolute standpoint, and not a relative one. For years Wall Street has promoted relative performance, hence. Investors believe that if their portfolios declined only 15% while the popular averages declined 20%, then they think they are a success. Nothing could be further from the truth. In terms of performance there is only one question to ask: “Have I made money or not?”
If you successfully limit your trades to those in which the risk / reward ratio is at least 1:3, and you properly limit the amount of capital you put at risk, you need only be correct once in every three trades to be profitable.
In the table below (courtesy, Victor Sperandeo Principles of Professional Speculation, p4) assume you apply the minimum 1:3 risk/reward ratio and are successful in every third trade, realizing our commensurate 3 bagger (profit 3 times the risk). Start by risking 3% (adjust as you see fit for your personal circumstances) of your initial capital. Then every time you bring your portfolio from the red to the black, you bank 50% of the gain, and make it untouchable for your accounting period. Then your trading record might closely resemble the performance below:
Capital Available = Initial Capital +/- (Gains/Losses) – Gains Retained. Total % Performance = (Total Gains < Losses >)/ (Initial Capital) x 100%. Table courtesy Victor Sperandeo Principles of Professional Speculation, page 6 To purchase this book, (highly recommended) visit our Library Section.
Assume you make only 30 trades in an entire year. If you extrapolate this table you will have an annual return on your capital of 27.08%, while never risking more than 3 percent of your available capital in any one position. If you now extrapolate this table in the other extreme, if you lose on 30 consecutive trades (a highly unlikely event) you would still have 40% of your capital available to build with.
I understand this is an oversimplified example. It does, however, illustrate the principles of preservation of capital, and steady, consistent performance very well. In the real world, however, you may lose 5 trades in a row, win the next 2, lose money on the next 4, and win 3 of the next 5. If you use this type of money management, however, and are right but 33% of the time, your results will be similar.
Take this 3% rule we have created for ourselves one step further. Risking 3% of your trading capital in any single position does not mean that you use all of your capital in one position with a stop loss order 3% below your entry price. Often, in this author’s opinion, you must risk more than 3% of your entry price. Depending on market volatility, or the volatility of the issue you are trading, a 3% price move is merely noise in the larger trend hopefully taking place.
Often your risk on any particular issue should be 10% to 20% below your entry. How do we reconcile this seeming conflict? Simply by defining your risk prior to entering and then adjusting the size of your position to accommodate both.
For example, let’s suppose your trading account is $100,000 (just to make the numbers simple). The 3% rule says that your maximum exposure should be $3,000. You are interested in purchasing XYZ’s common stock at $20, but due to your analysis of the current volatility of this issue or of the market in general, you realize you must allow XYZ the room to trade down to $15 (25% below your entry) before your reason for purchase has been negated. That’s a risk of $5.00 per share in this stock. Since our maximum exposure is $3,000, you divide $3,000 by the $5.00 risk per share, yielding a purchase of 600 shares. The formula is simply:
(Portfolio Dollar Risk (3% of available capital) / Dollar Risk per share) = Amount of Shares Purchased
In our example above 600 Shares of XYZ = $12,000 Commitment or 12% of available capital committed to this position. The risk (5 points x 600 shares) equals $3,000 or 3% of total available capital. Should the risk on the individual trade be more or less, the formula above will help you determine the amount of shares to be purchased.
There are many reasons to build and diversify a portfolio. First and foremost diversifying your funds over several different issues (in different industries or groups) will avoid excessive exposure to a single source of risk in the stock market. It simply means don’t put all your eggs in one basket.
Seasoned investors and traders alike know that you must catch the large moves made in individual stocks, at least as often as possible, to bring your overall performance into the all star class. When you build a diversified portfolio of issues, you have the ability to keep those issues that have not as yet negated their reason for purchase. This would allow you to let your profits run, while you also weed out those issues that are not performing well. Those should be replaced with issues you perceive to have better potential.
Just how much diversification is enough? Too little diversification increases your risk, at the same time too much diversification limits your portfolio’s potential. The extent to which your portfolio should be diversified depends on two guiding factors; 1) The amount of risk capital you have; and 2) your personal risk tolerance. There are many studies which suggest that depending upon the 2 factors mentioned, one’s portfolio should consist of no fewer than 3 issues and no more than 10. It is not my purpose here to determine these factors for you; my purpose is to provide food for thought in your development.
Many believe that when you diversify a portfolio, you should diversify with equal dollar amounts invested in each position. Using our XYZ example above, should you have a $100,000 portfolio size, you could decide to have 5 issues each equaling $20,000 of initial investment. An alternative method is to have an initial purchase (as stated above) of 600 shares or $12,000, and retaining the $8,000 for additional purchases of XYZ, if the position becomes profitable and the risk to our original ($15) is now moved higher. You could also build your portfolio using our formulae above until you have reached an adequately diversified level, and retaining the rest for pyramiding your winning positions which ever ones they may be. Again food for thought! There are many books in our Library section, and from our partner Wiley & Sons, to guide you in all the areas we have touched on. A good Library is an essential tool in any trader’s arsenal.
The Last Word
I sincerely hope we have encouraged you to think for yourself, you must do that to be successful. I have presented here, what this author believes to be sound principles to develop and manage your trading account. I would like to leave this section with some excerpts from one of John Maldin’s recent newsletters. You may view John’s work at www.2000wave.com, or email him at John@2000wave.com John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. I believe these excerpts will help convince you to think for yourself, and consider risk first. I really enjoyed reading this and I hope you enjoy it to.
The study I cited a few months ago from the National Bureau of Economic Research. Only a very small percentage of companies can show merely above average earnings growth for 10 years in a row. The chances of you picking a stock that will be in the top 25% of all companies every year for the next ten years is 50 to 1 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely they are to have an off year. Being on top for extended periods of time is an extremely difficult feat.
Yet what is the basis for most stock analysts’ predictions? Past performance and the optimistic projections of a management that gets compensated with stock options. What CEO will tell you his stock is over-priced? His staff will kill him, as their options will be worthless. Analysts make the fatally flawed assumption that because a company has grown 25% a year for five years that they will do so for the next five. The actual results for the last 50 years show the likelihood of that happening are small.
I have recently read a marvelous book by Nassim Nicholas Taleb called Fooled by Randomness. The sub-title is The Hidden Role of Chance in the Markets and in Life. He looks at the role of chance in the marketplace. Taleb is a man who is obsessed with the role of chance, and he does a very thorough treatment. While I have read many of his points, he gives us several totally new (to me) concepts. He also has a gift for expressing complex statistical problems in a very understandable manner. I intend to read the last half of this book at least once a year to remind me of some of these principles. I need to acknowledge his contribution to much of this next section.
Assume you have 10,000 people who flip a coin once a year. After five years, you will have 313 people who have come up with heads five times in a row. If you put suits on them and sit them in glass offices, call them a mutual or a hedge fund, they will be managing a billion dollars. They will absolutely believe they have figured out the secret to investing that all the other losers haven’t discerned. Their 7 figure salaries prove it.
The next year, 157 of them will blow up. With my power of analysis, I can predict which one will blow up. It will be the one in which you invest!
I’ve Got A Secret System
If you go to an investment conference or read a magazine, you are bombarded with opportunities to buy a software package which will show you how to day trade and make 1,000% a year. For $5,000 you can buy an “exclusive” letter (Just you and a thousand other readers, and their friends and clients) which will give you a hot options or stock tip. You will be shown winning trades which make 100% or more in a short time. You, too, can use this simple tested method to enrich yourself. Act Now. (Add 6.95 for shipping and handling.)
Full disclosure here: I am a manager of investment managers. I look for investment managers and funds for clients. Most of what I look at are in the private fund or hedge fund world. I get to see the track records and talk with the creme de la creme of the investment universe – the true Masters of the Universe. These are the managers available only to accredited investors ($1,000,000 or more net worth.) This world is growing leaps and bounds as more and more sophisticated investors and institutions are looking at these managers now that mutual funds and stock managers are having bad years.
None – not one – nada – zippo – zero of the best managers the world can deliver consistent results that you read about in these ads. The best offshore fund in the world for the five years ending in 2000 did about 30% a year. You can’t get into it. But in 2001 they were flat.
Steve Cohen can deliver some spectacular returns and has for almost 20 years. He has been closed to new money for years. But even this legend can’t put up numbers like I see in the ads.
Here’s the reality. If you could make 20% a year steady, in five years – ten at the most– you will be managing all the money you can run. Trust me, the money will find you. You will charge a 2% management fee and 20% of the profits. On $1 billion, that amounts to $60 million dollars in fees. That’s every year, of course. Why would you sell a system that could do 20% a year?
Once everyone knows about a system, it won’t work like it has in the past. One of the problems I wrestle with every day is trying to figure out which investment styles may be at the end of their run. Every dog has its day in the sun. The trick is to figure out when the sun is setting.
Now, saying that, there are exceptions. I get (or used to get, Rob) an email every day from a reader. Now I get weekly summaries. In it were his trades for the next day. He is uncanny. He is compounding at something like 300% year, with around 75% of his trades working. I called him and discussed his system. I was interested in starting a fund. The problem is that his style would top out (he thinks) about $1,000,000. After that, he would not be able to get enough trades. But he does nicely for himself. That means you could only have a fund for about $250,000 and let it grow, and of course there would be a thousand other problems.
Could he sell his system? You bet. But the minute he did, it would stop working.
I have looked at a manager in the Boston area. He has about the best sector rotation track record I have seen for the last five years. I called him up, wondering if I could place money with him. He said no. He will be at his maximum level, about $15 million, soon and then will have to close. I work with another manager who will soon close his fund at $250 million. That is all his style of investing can manage.
Every style has its limits, whether it is $1 million or $250 million or $1 billion. Just because you have a successful operation with 25 stores doesn’t mean you can expand to 500.
There are physical limits to everything and every system. Knowing your limits, and the limits of your investment managers, is critical. Many of the spectacular blow-ups have been from managers who do not understand the limits of their style.
Take the Janus 20 fund. This is a fund that focuses on the 20 “best” companies, mostly tech. They had an incredible record, and grew to manage tens of billions of dollars. This was good for the managers, as annual bonuses grew each year as well. They told their investors the secret to their success was doing their homework and being expert on analyzing companies. They were bottoms up value investors, looking for growth potential, and boy were you lucky to have found them.
They were a bus load of investors on their way to a train wreck. No one seemed to think the party would end. But when it did, they had no exit strategy or even the ability to exit. If you own $5 billion in Cisco, you are not a shareholder. You are a partner. You are stuck. If you try to get out, the market will soon get the word that Janus is bailing, and the shorts will eat your lunch.
In hindsight, their incredible track record was less brilliant investing and more simply was participation in the largest investment bubble in history, with no exit strategy. They got heads 8 times in a row.
Smaller investors and funds could have taken the exact same approach, but because they were smaller would have the ability to exit.
OK, here is a confession. There are thousands of funds and managers for me to investigate. When I go to my databases, I do a sort for high Sharpe ratios, low standard deviation, low betas and yes, good returns. Returns do matter. Then I begin to analyze. There are lots of questions to ask. First, I want to know “Why do you make money?” Then I ask, “How do you make money?” Then I want to know how much risk they are taking and the last question is, “How much money do you make?” (Besides the normal few score due diligence questions. For a list of those, see the Accredited Investor’s Membership Guide at http://www.investorsinsight.com.
Janus 20, to pick on them again, made money because they were in a bull market. Period. They lost money because they were in a bear market and they were a long only fund. Some “market timers” made good money in the last bull market, but lost their touch as we went into more volatile bear markets. The irony is that their systems need bull markets to be successful, but it was not until we were in a bear market that we knew that. Unfortunately, this was at precisely the time you wanted a market timer to work for you. So you have to find out what market they are trading in and look at their performance in light of that. That simple process will often tell you whether you are dealing with good managers or lucky traders.
Of course, if you understand “Why?” they made money in the past, you have to ask yourself are the conditions likely to remain in place for them to continue to make money in the future?
If they can give you a good reason for why they make money in their niche, then you start to look at how they do it. What is their system? Do they really have one or are they flying by the seat of their pants? Every manager has a proprietary trading system. You start with that as a given. There are lots of questions and analysis that is crucial at this point.
As an aside, if a manager tells me about his unique trend-following program, I end the interview. To me, a trend-following system is just a system that hasn’t blown up yet. In my experience, the percentage of trend-following systems which have experienced train wrecks after spectacular ten-year track records is way too high. I simply do not have the skills to figure out which ones are going to still be flipping heads in ten years, and which ones are going to crash, so I just leave that arena to smarter managers than myself.
I am consumed with wanting to know how a manager controls risk. I understand that you can’t make above market returns without risk. But not all risk is apparent from past performance. (The blow-up by Long Term Capital comes to mind. Right up until the end, they were as steady as you could find. Then: kA-Boom.) All styles will lose money from time to time. I want my risk to reward to be reasonable and controlled.
When I meet a manager, and all he wants to do is talk about his track record, I find a way to quickly close the conversation. When they tell me they are trying to make the most they can, I head for the door. Maybe they are the real deal, but my experience says the odds are against it.
It is not settling for being mediocre. Statistics and experience tell us that simply being consistently above average is damn hard work. When a fund is the number one fund, that is random. They had a good run or a good idea and it worked. Are they likely to repeat? No.
But being in the top 50% every year for ten years? That is NOT random. That is skill. That type of consistent solid management is what you should be looking for. Isn’t that what you are looking for in your trading account?