As the markets tumble and all about you are losing their heads, you need not lose yours
Is it finally over? The Market Horror Picture Show is lurching to a close. What fresh horrors will 2009 bring? And how can we be ready?
You know it's been tough when even the brightest minds in the investing world are running for the hills.
"What a sick beast this is," complained trader Stephen Vita in a post on his Alchemy of Trading website a few months ago. "This market is exasperating, and I'm frankly more than a little sick of the whole thing."
Even the world's richest man has gotten stomped. Warren Buffett's Berkshire Hathaway crashed an astonishing 50 percent from its high of last year to their lows of this fall's selloff, before recovering a little in the last few weeks.
But if the planet's best investor is on the run, what hope is there for us average schmoes? How can we possibly survive 2009, a year we're being told could be even worse?
Advice, as usual, is all over the place. "Hold tight, things will eventually turn around," say some. Or: "Sell now! Or you could lose everything."
Still others say, "Buy! Valuations are cheap."
Who is right?
I don't know. Nobody does.
This, I think, is the lesson of our times. Insanity is the new normal. Here's a typical market day: stocks shoot up 5 per cent in morning trading, crash 10 per cent by mid-afternoon, then rally to close even for the day.
We've seen enough of this kind of action to safely say it's impossible to know what tomorrow will bring in the markets.
So what? you ask. You knew that already. The question is, do you actually act as if you have no clue what lunacy tomorrow's market will bring?
Not if you're anything like most amateur investors. Most of those I know act as if they have some secret knowledge about the future - even when their past mistakes prove they don't.
Case in point: I was recently talking about the markets with two people who shall remain nameless - both of them sharp, careful businesspeople.
They had both independently arrived in the same pickle. They bought energy stocks at the height of the commodities boom last spring; the stocks had since crashed 80 to 90 per cent. They had lots of chances to sell as their holdings were decimated.
They never did. Why not? Well, they didn't want to miss the inevitable rally that would let them at least get their money back.
Out of pride or misplaced hope, they were ignoring some basic math. The stocks must climb times for them just to break even-an unlikely concept in the foreseeable future. The odds are probably just as high, in fact, that those companies will pull a Nortel and be penny-stocks. Some could even fold.
The fact is both people knew they had failed miserably in predicting the future. But by refusing to sell, they were still acting as if they could predict.
I don't think they are so different from many under-water investors out there. Despite the devastation of the Crash of '08, I think too many of us are still pretty deluded about how we approach the markets.
And this is what I think separates amateur investors from the pros who trade for a living. I think it's a key for surviving the times ahead.
The traders, at least those who are successful, know what they don't know. And they act accordingly.
Meanwhile, the rest of us too often don't. We paid the price for that hubris in 2008. And we could pay again in 2009.
It's not just you and I who have a hard time making money in the markets. It's often said the best traders typically make a profit on only 60 per cent of their trades.
So how do they afford their Porsches, country villas and Brioni suits? It took me a long time to get this, but the secret isn't insider information or expensive computer trading software. They profit by controlling risk.
Risk control isn't just for professional traders, of course. Limiting our vulnerability to bad things is something we do all the time. Think about how you approach the other unknowable things in your life -the risk of STDs, theft, accidents, death.
We try to minimize the chances something will go wrong by wearing protection, locking our doors, buckling up, wearing a bike helmet when rolling down the hill in a shopping cart. And, just in case, we get insurance.
But most people seem to have a completely different approach when it comes to investing. In fact, the market may just be the place people take the wildest chances with their livelihoods, with the very fewest precautions.
Is there an investing equivalent to insuring and locking your house?
Fortunately, yes. We can minimize risk with a few simple investing rules. Such risk-control rules are common knowledge among professional traders, but they're still little-known to average investors, despite the freefalling markets.
The rules all boil down to this: If we truly don't know what grenade tomorrow's market will lob at our heads, always be ready to duck.
CUTTING YOUR LOSSES 101
Here are some simple risk-control rules commonly used by professional traders:
Decide when to sell before you buy: Buying is often easier than selling. When do you cash in if your stock goes up? When do you sell if it craters? Most everybody has an ouch point—even a buy-and-hold investor. Is it after losing 60 percent of your assets? Ninety percent?
The pros tend to avoid this conundrum by picking their selling point before they buy. It’s their way of admitting they don’t know what’s going to happen in the market.
A simple way is to look at a chart. Take the S&P/TSX composite index. It bottomed at 7647 in late November and has since gained 1,000 points. Not bad. If I were to buy it today, I might place my sell point (often called a “stop”) below a recent major low (like 7647) or the 20-day moving average.
Traders often set stops a little below such levels because they don’t like to get stopped out by regular market noise; they want to sell only because of a serious breakdown.
I use the same rule to figure out when to sell a winning stock. For example, I might place my stop one or two percent below a stock’s 20-day moving average and adjust upward as the price rises. That’s called a trailing stop.
The exact stop level can be adjusted based on the timeframe of the investor. A long-term purchase could use a stop 10 percent below a major multi-month low or the 50-day moving average; a very short-term trade may use a stop one percent below a recent low or the five-day moving average.
(You can view free charts of Canadian and
Size matters: Knowing when to sell tells me how much money to risk on an investment. A common rule-of-thumb is not to risk losing more than one or two percent of total assets in any single trade.
In our TSX example, say I buy the index at Tuesday’s closing price of 8742 and my stop is 7532. That equals a 14-percent loss if my trade goes sour and my stop is triggered.
A little math tells me I should invest no more than 14 percent of my portfolio in this trade if I can’t stomach losing more than two percent of my total assets (100 percent divided by half of the 14-percent potential loss).
Diversify: Stops and appropriate positions don’t help me much if I’m 100-percent invested in a single sector that goes belly-up. If my stops are hit at the same time in 10 energy companies, I’ve just lost 20 percent of my Freedom 55 fund. Sayonara, beach house.
That’s why pros often put no more than 20 or 25 percent of their assets in any one market.
Cut your losses: “To make great sums of money,” trader Paul Tudor Jones once wrote, “you first have to learn how to lose much smaller sums of it when you’re wrong.”
I had my own lesson about this last fall. I often invest with a mechanical investing system that I developed. Last summer, the market data started to hit extremes it had never seen before. Signals were often wrong and costing me money. I wasn’t down as much as the broader market, but enough to make me take a closer look at my approach to risk control.
I realized I had no rule for when the market data was acting completely out-of-line with historic precedents.
To account for this I adopted a slightly adapted version of another commonly used trading rule: If my portfolio loses more than six percent in any four-week period, I sell everything and go to cash. Call it a time-out for a misbehaving market.
I adopted this rule just in time to sidestep the worst of the market carnage in October and November.
When the time-out was over, I was set to jump back into the markets just as they rallied powerfully in late November and December.
Has the market finally bottomed? I don’t know. I do know the market can turn on a dime. And if I want to survive, I must, too.
Which brings me to another good trader’s rule: get a little Zen. Lose the pride and don’t be sentimental about an investment. It’s money, after all, not romance. Emotions are the worst enemy of an investor. If I’m wrong, I try to learn something and move on to the next idea. I think of my loss as a tuition fee.
This approach was captured nicely in the movie Kung Fu Panda. “Master!” says the kung fu teacher. “I have… very bad news.” “Ah, Shifu,” the wise old turtle replies. “There is just news. There is no good or bad.”
Hey, that really is a wise old turtle. Perhaps Mr. Buffett could use a kung fu lesson. Perhaps we all could.