In starting part three of three of our series on investor psychology, behavior and management, let’ s revisit the magazine article that stimulated the series in the first place.
In the October 2010 edition of Advisor Today magazine, Stephan Cassidy’s article “The Psychology of Investing” contained the following statement that I cannot find any argument with whatsoever:
Behavioral mistakes caused by unchecked emotional responses to events are the single biggest reason most investors do not do well.
Stephan tells us that investors buy when it seems safe to do so — i.e., when the market is doing well — and sell when they are scared — i.e., market down. Hence, he says:
Investors are hard-wired to buy high and sell low.
We also learned in part one of our series that research among retail investors indicates that they would rather sell their winners than their losers. Clearly then, as individual investors we should divorce emotions from our investing decisions as much as possible. One way to do this is to adopt a system or plan that is rules-based and that we stick to the plan and rules.
In our second article we looked at several systems that moved us in and out of an investment, in that case the Wilshire 5000 index according to market conditions. Over the five-year period tested buy-and-hold was the worst performer, our Paladin 200-50 system was the best. Investors should adopt a system that will protect wealth in longer down-trending markets, yet allow re-entry without giving up too much of the upside. We feel that our Paladin 200-50 system achieves such a compromise. It is worth noting that at the time of writing none of the major market index ETFs would have been sold by our system during the recent downturn, although the Nasdaq composite did close below its 200-day SMA today. The only sector SPDR ETF that would have gone on the block so far in this downturn is Financials — at the open on 6/8/11. Technology and Materials are also below their 200-day SMA but have not triggered a sell yet. XLK, technology, may very well trigger tomorrow.
By the way, our Paladin 200-50 system beat buy and hold by 55.8% with one-eighth the drawdown and only twelve triggered trading events in five years.
Remembering that these models were directed solely at the long-term investor, how else might we implement procedures to save our portfolios from our unchecked emotions? And so it is we come to this final chapter — exits.
I am certainly not the first writer to point this out but, I think it is fair to say that if investors, traders and trinvestors put as much work and effort into knowing when they would sell their holdings as they do in buying them, we would probably not be having this conversation now. My guess is, they never will. High-frequency traders might, and the ones who are actually making money almost certainly are. Such traders generally have a pretty clear picture of when they will sell before they enter the trade. As investors, maybe we can’t do this, because we don’t have a clear idea of where the top in our purchases is.
VectorVest has a facility in its backtesting model that allows a stop to be triggered on a pre-set profit percentage as well as a loss. In a number of cases where, usually, a high portfolio turnover is expected — that is where the stocks meeting investable criteria change rapidly or frequently, somewhat like out IBD50 top-10 portfolio — this method works well. But, invariably, some money is left on the table. For example, in our model IBD50 portfolio, Netflix is still carrying a 42.57% gain over its purchase price on January 23rd. As investors, why would we want to limit that gain? But, we also have to protect our portfolios from losses.
Warren Buffet is attributed as saying that Rule One is never to lose money, and that Rule Two is always to remember Rule One. Sadly, I cannot live up to Mr. Buffet’s expectations as I sometimes lose money, and it always hurts when that happens. But, I try to limit the pain to manageable proportions and avoid portfolio-destroying losses. And to keep everything in perspective, this is not a game. Many investors are in what I call the retirement minefield. That is, roughly ten years to retirement and not enough money. They can’t retreat to the safety of the bond market (if such a thing exists), but they can’t afford material or catastrophic losses either.
We can and should make a start in portfolio protection before we purchase a new position. How is the market behaving? Steady trend, or some volatility? Same question for the position to be acquired. What’s our expected holding period? What are our expectations for this investment? Let me give you an example. One of my portfolios has a ten-year window. I own some oil positions in it, because we can argue about the price of oil this year but I think we can all agree that it will be costing more in 2021. So, I may set slacker stops in this case, having a very long-term and somewhat certain view, than I might say, for the oil ETFs I bought a while ago to park money for a new car I was going to buy. BUT, I always set a stop as soon as I execute a buy order. (I had to learn this the hard way, for what it’s worth). Typically I will set a hard 7% stop, and that is the default I use. I may use higher or lower depending on volatility and trends, but I always set a stop.
So that’s done, but then what? The first thing is, every investment you own should have a stop. That doesn’t mean that each stop should be cast in stone — in fact they should be dynamic and you should review them routinely. Unless we are in a period of market uncertainty, monthly should work.
Once you have built up a certain amount of gain, I typically transition from a hard stop to a percentage trailing stop. The percentage can change and may be different for each position. Maybe you are sensitive to not being whipsawed out of a position, particularly if it is in a taxable account. Then, depending on how much profit you have accumulated, you may choose a larger trailing stop to accommodate some volatility. Or, it may be that you are sensitive to protecting profits — I have taken this position during the current correction and most of my positions have liquidated leaving me with a profit. I will pick back up when I see the market turning.
I have begun to use my TC2000 software from Worden Brothers as a real tool in managing my portfolios. It has an alert system that will message you in the program if you are using it at the time and e-mail you at a primary and a secondary e-mail address. But please remember, alerts are NOT a substitute for a stop. What I suggest is that you set an alert above the stop so you have time to check what you want to do, although, frankly, if you set the stop properly the alert should be superfluous. Where this becomes useful is in managing long-term holdings, particularly in a taxable account.
Where TC2000 really comes into its own is in both monitoring assets and in calculating and setting stops. Below is a full-screen view of TC2000 as I have it set up to monitor a small portfolio: (click on the image to view it full-screen)
There is some key data highlighted on the screen.Particularly, I can see what size of gain I have accumulated in the position, critically, how close the position is to its 200-day SMA, whether it is above its 50-day SMA or not and its average true range (ATR) in this case, based on a 14-day period. And news relevant to that position which may influence your stop calculation.
After I had decided the current market correction needed my attention I built an Excel spreadsheet, by portfolio, by position. I calculated cost, market price and hence gain. Then I calculated stops at a range between 7% and 10%, and at 1x, 2x and 3x ATR. I also calculated how much gain I would have left, by position, depending on which stop I selected. I then judgmentally picked a stop by position and set it as a percentage trailing stop, guarding me to the downside but allowing for upwards movement too. I revisited the calculation every week. I’m happy with the profit protection that I have achieved.
One can also show, and adjust, volatility stops in TC2000, as illustrated:
But even at a basic level, assuming a long term view and the use of the 200-50 methodology, one should set a fallback stop set at x% or $x below the 200-day SMA price so that in the event of a sudden sell-off, your position has some protection.
Another tool that I have really come to like is Smartstops. I cannot recommend strongly enough that you take a look at their service. They do far more than I can relate in this article, but for the lazy or busy investor I really think they are the way to go, with a backup hard stop set should all else fail. Many things go into calculating a Smartstop, but they are adjusted continually and respond to volatility. You can even differentiate between short-term and long-term holdings and the stop calculation is adjusted accordingly. They also have many levels of service to pick from — at a Cadillac level you can have your orders populated at TDAmeritrade, if that is your broker. But at a basic level, the service starts at $9.95 a month and quite frankly, for the price of a trade, I see this as simple and cheap portfolio insurance. Smartstops will e-mail you an alert during the day if there is an alert, or if a Smartstop is triggered:
At the end of the day you will receive a comprehensive report on all the positions you are protecting at Smartstops. This is part of one of the end-of day reports:
The arrow is pointing to something that really differentiates Smartstops and which in my opinion is extremely valuable. That is a re-entry alert. I think it was Stephanie Pomboy of MacroMaven who stated her dislike of stops because having been stopped out of a position, one doesn’t know when to re-enter the position. If you are using the Paladin 200-50 system, then the system will dictate the re-entry point. Other “crossing” systems will too. But otherwise, it is a problem. Smartstops has this solved as they will e-mail you a re-entry alert for a position they have stopped you out of, alerting you to the opportunity to buy back into your position:
If you are using Marketclub then a green monthly or weekly trade triangle could safely be used as a re-entry point.
Everything I have illustrated in this article using TC2000 or Smartstops you can absolutely do for yourself as there are plenty of free resources available to you on the Internet, it will just take more work. But, the major take-homes really are:
- Set a protective stop immediately after purchasing an investment.
- Stops are dynamic and you should review and adjust them regularly. We suggest at least monthly. And once they are set, absent a major change, LET THEM DO THEIR WORK.
In closing, let me offer an opinion that is contrary to what you read in most guides. When you set a stop I suggest you set it to execute at market. I have had very good experiences with my broker getting me the best price available and did you know that market orders are executed ahead of limit and other orders? Some say you should use limit orders to protect against too much downside — think the flash crash — but the first time you end up stuck in a position because your limit order stop didn’t execute and the price still went down leaving you in a hole you may think better of market priced stops. As you can tell, it’s happened to me. In a flash crash, it may be a problem, but otherwise, I think they are the safe option.