Once You’re Up, You’re Up For Good.

Once You’re Up, You’re Up For Good.

For decades now the conventional wisdom has favored a more aggressive investment portfolio for a person of a younger age — when he or she can afford to weather more volatility — and a more conservatively biased portfolio for persons at a more advanced age, when capital preservation takes primacy over higher returns. Such counsel rang true enough in its day, but over the next few minutes I hope to make the case that paradigms in finance have shifted so dramatically as to render this oldest of investing maxims all but toothless, if not actually flat-out wrong.

This is a long column but do bear with me because, at the end of it, I’ll be showing you what I think is the new, better way of managing risk across all segments of the age-and-demographic spectrum: an updated metric, functioning as the modern analog to our old rules about risk-return correlation, complete with a live example. The entire column will take about twenty-five minutes to read.

We’ve all seen and appreciated the many important change-agents that have upended the world of amateur investing in the past quarter-century, but to my mind the principal actors in this paradigm shift have been the emergence of inexpensive brokerage options for rank-and-file players like you and me, and the inclusion of functionalities in those accounts which were heretofore exclusive trading features for the very rich — notably the capability to set stop-sell orders on one’s individual positions.

In order to appreciate how something as seemingly innocuous as the availability of a good-til-canceled stop-sell feature in a basic online discount brokerage account might just have upset the entire apple cart of our conventional thinking about investing, we must first retrace the pedigree on just how the conventional wisdom became so conventional in the first place – let’s say by going back fifty years to 1968. At that time, an insurance agent making decent money for himself and his family could certainly own stocks: but only if he opened what we would now call a “full-service brokerage account,” under whose terms he would need to contact a paid professional — his “broker” — to make a trade. Generally this involved a series of telephone messages left back and forth, and generally the resulting trade would be assessed a hefty commission (often as much as five to seven per cent of the total value of the trade).

The reason this matters to one’s risk profile comes down to timing. If our friend the insurance agent is twenty-five years old, he would actually be much better served by purchasing highly volatile assets for his portfolio — in part because of these restrictions on his range-of-movement. Higher-risk assets enjoy the highest returns (still true even now, because it has to be or those assets wouldn’t sell), and thus they offer the young insurance agent his greatest likelihood of making a good return. That is, provided he is patient enough to ignore the short-term swings and focus on where those riskier assets are likely to take him by the time he’s ready to retire. He loses his necessary five percent up front, but then he takes every quarterly statement he gets in the mail (?anyone else remember mail?) and throws them summarily in the garbage. Forty years later he’s a rich man, all being well.

If on the other hand our insurance agent is already nearing retirement, the above-described rules of 1968 present him with two artificial and pretty big reasons not to buy into any high-wire acts. First, if those assets start to tank, they’ll probably lose a decent chunk of money – and this, remember, is money that was expected to be taken home from the grocery store and eaten in about ninety minutes – before the poor schlub can even get his broker on the damn phone. And second, especially if he’s only just bought the asset in question, he’s going to get creamed on the commissions at both ends of this artificially short timeline, to boot. Remember: even if the asset breaks even, he’s out ten percent.

Thus has it always been that we tell our aging middle-class speculators to gradually but methodically shift into more conservative assets with smaller returns. Yes, those who take our advice will lose out on the ongoing opportunity to reap the biggest benefits from the highest flyers — and in so doing they would inoculate themselves against the risk of losing contact with their brokers and/or getting taken to the cleaners by steep commissions when they feel they need to prematurely surrender their positions before they lose too much near-term spending power.

But here’s the thing. Neither of those two age-related reasons for shifting to more conservative holdings still applies in anything like the severity that it used to. The world of investing just doesn’t work that way anymore.

Instead, what a person can do now (especially in a bull market), is use one of the many discount online brokerage accounts out there to take on a much more aggressive/volatile posture with his portfolio, and then independently ensure against downside moves by setting up good-til-canceled stop-sell orders on everything he owns.

Since these are two different steps in the prescribed strategy, and since they respond to two different changes in the industry, I’ll treat them separately here.

First, and at the risk of offending in my very first blog post, let me say with a clear voice that I can see no real reason for anyone anywhere ever to use a full-service, full-commission broker for one’s investing anymore — regardless of age or strategy – ever again. The online brokerages don’t offer counsel (unless you pay extra for it), but these days the counsel for which you might have expected to pay, is instead bundled into the decision making of the fund managers who run mutual funds and ETF strategies. If, for example, an individual investor happens to think that the tech industry is the way to go for the foreseeable future, she can park her savings in a tech-oriented mutual fund or ETF, and know that someone, somewhere, is making a good living by deciding exactly *which* tech stocks the investor will end up holding indirectly, by virtue of owning shares of the fund.

As an added benefit, our hypothetical stock-picking expert at the mutual fund company doesn’t experience the same conflict-of-interest that a full-service broker does, since each time the fund expert makes a mistake it *hurts* his standing with the individual investor, rather than masquerading as another excuse to make another five percent off of her, by adroitly changing his buy recommendation to a sell or vice-versa.

The JLI is personally with Charles Schwab, but that’s not an endorsement: There’s no real reason to prefer one of the big players in the discount on-line brokerage space to any of the others. These days they all charge roughly the same fee (about $6 per trade), and they all offer roughly the same range of support on their websites. I could just as easily be with TD Ameritrade, or Fidelity, or any of about a dozen others, and I’m sure my experience wouldn’t be materially different. I just wanted to say that this is who I’m with because later in the column I’ll be posting screen-captures, and we don’t want to waste concentration-power trying to recognize the typefaces and the web design. Spoiler alert: It’s a Schwab account. And I pay six bucks every time I make a move – unless their website frogs up for a day and I complain about it, in which case I don’t pay anything at all for about two solid months. (They love me at the Friday-morning CSM meetings in Dallas, I’m sure.)

So, okay, commissions have gone from five percent of the trade, to a flat six dollars. Great. But saving most of five percent per trade won’t stop a sixty-something insurance agent from losing his grocery money on risky assets — at least by itself: the same basic problem would apply as before, just at a five-percent discount. Except it doesn’t. And the reason it doesn’t is that the discount brokers haven’t stopped at offering a discount. Through the sheer force of intense market competition in their business space, they have all gradually brought increased functionality to the Joe Lunchpails of the world – functionality that had always been the exclusive purview of the super-wealthy — and the specific type of functionality that we all get to enjoy like never before, and that is also relevant today, is the stop order.

A stop order is an order to sell (or buy) an asset if it reaches a certain price. In the case of a stop-sell, the stop price is set below today’s price, and the order executes if the price falls to the investor’s designated threshold. Stop orders can be “day only” or “good til canceled,” or even “fill or kill,” and they can easily be changed, parceled, or canceled at any time. And you can make these changes as often as you like as long as the order hasn’t triggered, because the website will never get bored or exasperated with your constant tinkering. Because it can’t. It’s a website. It doesn’t care.

As an example, let’s look at an India-based ETF that I own a few shares of, called INDA, trading at about $37.70 at time of writing. Suppose I wasn’t sure INDA was going to stay up and I wanted to be sure that I didn’t lose money on it. And let’s say I bought it at $34.50. In that case, the simplest move of all would be to set a stop sell order anywhere between today’s price and $34.50 — or even right at $34.50 if I didn’t mind losing twelve bucks. And arranging things this way would be a simple question of clicking through a series of drop-down boxes:

 

The relevant part of which is ….

I’m not actually going to place this order — but you can see how easy it would be for me to say, “Whatever else happens, Chuckster-Baby, do NOT let me lose money on this thing.” All I’d have to do is set the stop-sell order at the price I paid, and I would know from *almost* the first moment that I’d bought the asset that there was no possible way that it could cost me grocery money.

Then, when the fund *did* start to appreciate, I could check in on it once a day after the close (or, since I live in Cambodia, I could check in on it once a day before the open), and nudge my stop-sell threshold by the exact same amount as the fund had gained on any given day, thus cementing the day’s appreciation as a gain that couldn’t subsequently be taken from me by downstream volatility. As long as I didn’t mind checking in once a day to log the moves of the various positions in my portfolio, and to adjust upward the stops of all the assets that were up for the day, I would quickly and easily ensure that those funds always paid me in the black, no matter what happened later.

The whole thing works like a bad case of jet-lag. Once you’re up, you’re up for good.

Okay, before we go any further, two big caveats:

One thing that is no less true than it was in 1968 is that if the individual investor guesses wrong on a short timeline, she’s going to lose money. Financial assets can and do lose value, and we’re used to expecting a certain amount of such risk as part of our bargain. But there’s no reason for the individual to wait to set her stop-sell order until after her position has crossed into positive territory. Instead she can set it right away, the moment the buy order has gone through (or three days after the buy order has gone through, if she’s buying with unsettled funds), and she can dial in what looks to her to be a reasonable loss, given her own personal risk tolerance, and the past volatility of the asset.

I *always* do this. I’ve been trading aggressively for about fifteen years, and over that time I’ve probably owned a hundred different assets – of which ninety or so were ETFs and the other ten were used stereo amplifiers that showed up at my house already broken. (I’ve done better with the ETFs, generally.) And I never, *ever* buy an ETF without immediately setting a good-til-canceled stop sell order on the exact same instrument. Naturally that first sell threshold of mine slides up and down with the risk profile of the individual ETF, and with my current liquidity, and with how my other assets are doing, but I never, ever, *ever* leave my downside flank completely un-defended. Why would I, when the insurance premium against unlimited downside will cost me six measly dollars?

The other thing that amateur investors don’t always expect or understand is that the price you can get for selling an asset will always be a certain, hopefully small, but variable amount *smaller* than price you paid. If you’ve already dabbled with investing, you’ve probably seen this and it’s probably pissed you off: You log into your account, buy 1,000 shares of Apple (or whatever), and an hour later you refresh your positions page and the stock is up five cents, and your account is *down* by a couple of hundred dollars!

This is called the “bid-ask spread” and it’s very important to know and understand how it applies to a specific asset you might be thinking about, before you buy it. I forgot to check the bid-ask spread once about four months ago, and discovered a day or two later that the asset I’d bought had a spread of ELEVEN DOLLARS PER SHARE, or about twenty percent of the price I paid. That means that the asset needed to appreciate by twenty percent – plus the twelve bucks in commissions at both ends – before I could sell it for even money.

This would be a topic for a completely different column (indeed it soon will be) but the reason it’s relevant in the present context is that you cannot set your stop sell order at the exact price you paid, on the very first day, or you’ll stop out immediately and lose the amount of the spread plus the two commissions. And that wouldn’t look good in the comment field below this article, so let’s skip it.

What remains for us instead, is to try to motivate the idea of how a stop-sell order could be wielded by a more conservative investor in a manner that allows him to have his cake and eat it too with an otherwise risky portfolio. And that’s the whole power and beauty of stop-sell orders. Because you get to pick the stop value, you can write your stop sell orders with a completely different strategy in the back of your mind, depending on where you are on the age-and-demographic curve.

The rest of this column is about how to adjust those *strategies*, in lieu of adjusting the risk profiles of the assets themselves, as a person ages and grows more dependent on capital preservation.

Let’s consider the example of three investors, call them “Joe,” “Dave,” and “Richard.” In our example, Joe is thirty-five and making decent money with few expenses. Dave is most of fifty and stupid but manages to keep his head above water by occasionally being less stupid, if not actually any less of fifty. Richard is sixty-five and semi-retired and doesn’t expect to want to do what he’s doing forever – because who would?

In times previous, the advice we would have given each of them would have been materially different: We would have told Joe to go long on the riskiest stuff he can tolerate (after buying a really nice house just a couple of blocks from Satchell’s Pizza), and we would have encouraged him to ignore his holdings as soon as he’d settled on them. He’d thence be up one day and down the next, but as long as he ignored the vagaries of the short term, he would make more money by parking his chips on the riskiest squares he could stomach. Maybe Joe thinks Brazil has a high long-term upside, and so after a few days of research he finds a downright hilariously volatile ETF called iShares Brazil Index Fund (ticker symbol EWZ) that outperforms the more conventional markets — when it isn’t losing a third of its value overnight.

Dave, we would tell … well, we would tell Dave a *lot* of things, but he isn’t going to listen to any of them anyway, so let’s just leave it at telling him to start phasing-down his risk profile in increments. Maybe for now we’d move him off the Brazil nonsense and into, I dunno, how about a Dow-30 ETF (ticker symbol DIA). We’d encourage him to take profits where he can, and gradually shift into quieter, more income-oriented holdings like REITs and investor-owned utilities.

We would probably advise Richard to stick mostly with cash, but if he wanted to go a *little* bolder than that, we’d probably tell him to favor something from the low-volatility product space, such as the S&P Low Volatility Index Find (ticker symbol SPLV).

Okay. Let’s look at how the Dave and Richard would have done over the past two years, and leave Joe out of it for now since he’s got a closing to get to. Here’s what the past two years of returns would have looked like for the second and third funds named directly above, normalized to the same truncated vertical axis:

Yup. Everything about as we’d expect it to be: The DIA fund is slightly more volatile than the “low volatility” SPLV, and it pays a more-than-slightly better return. Both exactly as we’d have expected. At the end of two years, Dave is up 60% and Richard is up about 35%. This is dog-bites-man stuff, so far, so let’s go ahead and plot EWZ to the same vertical scale over the same two year period, and … see … what … happens ….

GAAAAAHHH!!!!!!

Dude, seriously.

I mean, if that last one just looks like another squiggly line – and it well might – then do bear in mind that the orange one represents all the volatility of the Dow Jones industrial average for an entire two-year span. By contrast, EWZ experienced more volatility in a single day, and on more than one occasion over the same period. Clearly that Brazil fund is just *insanely* volatile. I can’t – and don’t (!!!) – recommend it to anyone, by the way. Not even Joe. I’m in it for the amusement value alone, and at a *very* small cost-basis, because it really is hilarious.

I stacked the deck to make my point, so bear with me a little longer while we imagine that instead of buying these three different funds, suppose all three of these guys bought EWZ exactly two years ago. And before you say it, yes, the fact that EWZ happens to be up right this minute, instead of down 30- or 40% in a single day as has happened several times before, is making this idea look artificially smarter than it really is – but I’m here to tell you that it doesn’t, actually, *matter* for jet-lagged investing. Because the instant this wasn’t true, to varying degrees, all three of our friends would stop out.

Take Joe’s stop strategy first because it’s the easiest to talk about. Joe is young and he’s been conditioned to expect, even ignore, volatility. Because of which, he might not have stopped out at anything above break-even. This is smart investing for a young buck like him, since the looser he sets his stop, the greater his chances of riding the tiger through any local minima he encounters along the way to an even bigger gain.

Dave probably doesn’t want the heartburn of thinking that he could end up getting his money back and no more, so once the fund is up enough he’ll probably set a broadly permissive stop — somewhere above his entry price but still low enough that he can enjoy the ride for longer than the first blip. Each time the fund gains, he’ll note that in his log and bump his stop by the same amount. When it triggers, he is guaranteed to be up.

And Richard? He sets his stop to cash out at the very first whiff of real trouble, and scrupulously bumps it every penny that the fund increases, every time — even intra-day if he doesn’t mind the extra effort.

But that’s jet-lagged investing in its purest aesthetic, right there. Instead of settling for a measly 35% over two years (ha, ha), Richard can have his cake and eat it too by marking an extremely tight stop-sell value, and then just bumping that stop value, penny-for-penny, every time the fund is up. Once he’s up, he’s up for good.

Let’s muddy-up our two-year return graph with some specific scenarios.

Joe’s the easy one. He sets his stop at the entry price, never stops out, and two years later his initial investment of $10,000 is about $25,000.

Dave? Let’s say he wants to be sure he gets his first $1000 out of this, as soon as it’s up that much, so he starts with a break-even stop, and then adjusts it to +$1000 all at once as soon as he can. But he’s not finished there. Because every dollar after that is unanticipated profit, he ensures that he won’t stupid himself out of the whipped cream by raising his stop value, penny for penny, every time the fund goes up, and then not lowering it again when the fund goes down. By this metric, he stops out in early November of 2016, on the occasion of a massive one-day selloff in the Brazilian market – and yet he *still* doesn’t have to kick himself because his $10,000 initial investment rocketed up to $18,000, net of the one-day crash, in about ten months.

For his part, Richard isn’t in this to make $8,000 in ten months. Neither could simply kick back and watch the sorts of things that subsequently happened in May and September without it getting to him, and he knows that in advance. So let’s say he sets his stop at $400, and just like Dave he nudges it penny-for-penny every time the fund is up, but never nudges it back down. Accordingly he stops out in mid-May with $15,000.

He’s our loser in this story, right? Because if he’d stuck the money in the Dow-30 fund he’d have $16,000 instead of $15,000, right?

Nope.

Remember, Richard wasn’t being *advised* to go with the Dow-30 ETF; he was being advised to go with the even less volatile SPLV, which only would have garnered him about $13,000 — over the *entire* two years. And herein lies the second reason why Richard isn’t disappointed to stop out so soon, because he’s still got a year and a half to find some other asset on which to try the same tricks with his fresh $5000, and this time it’s house money. This is jet-lagged investing. Once he’s up those extra $2,000, he’s up for good.

A disclaimer, of sorts: I won’t be one of those guys who takes a historic bull market as his signal that he, personally, has figured out some genius strategy with which to beat the system. As Mike Tyson once famously said, “Everybody’s got a plan until he gets hit in the mouth.” Equities are globally overbought right now and a big correction is no longer so much a question of whether, as a question of when. Indeed I’ll be writing an article in the next few days about what a person might start looking into right now, in terms of attractive instruments for the coming bear market. (Spoiler alert: There’s going to be a lot of dividends and a lot of real estate in my coming-bear-market watch list, but no bonds. Never buy bonds when interest rates are this low. Ever. No matter what. Anyone who tells you to buy bonds right now is someone you never have to listen to again.)

I also can’t, of course, tell you which specific equities, ETFs, or mutual funds, to buy. I wouldn’t even if I could, but I also can’t. I’m stupid — and it’s finally starting to feel kinda okay to me to be stupid. I was pissed off about it every day for about the last forty-three years, but that got boring. These days I just watch bicycle crashes on YouTube and let the world sort itself out. Cambodia is a good place for that.

All of this being said, as long as the bull market continues there really is no reason to miss out on it – provided one sets his or her stop values at reasonable thresholds for the amount of risk and volatility that may be tolerated and expected with a given asset.

And when things *do* start to correct, we’ll all just politely stop out, and the extra cash will be ours, just for checking in on these things once a day.

Happy hunting.

Dave O’Gorman
The Jet-Lagged Investor
Phnom Penh, Cambodia

Article uploaded on 23 January, 2018
11:20PM Indochina time,
11:20AM Eastern Standard Time

Leave a Reply

Your email address will not be published. Required fields are marked *