The logic-flaw in a trailing stop … the unique “fingerprint” to each stock you own … goosing your portfolio returns without heavy tinkering in portfolio
As we look at the market today, we have a COVID-19 resurgence … the potential for more lockdowns … renewed trade-war tensions with China … a potential trade-war with Europe …
Despite these concerns, stocks continue to grind higher. It’s setting up an uneasy tension …
On one hand, you could sell now, only to watch the stock market continue its relentless march higher. A year from now you’ve missed double-digit portfolio gains.
On the other hand, you buy back in (or add more to your positions) now, just in time for one of the above concerns to finally rattle Wall Street, tanking stocks. A year from now, your wealth has been chopped double-digits.
This tension points toward a question each one of us has to answer as an investor …
***How do you keep your money invested, benefitting from market strength, while simultaneously protecting it from a market collapse?
If you really dig into this, you’ll find yourself facing a second question on a stock-by-stock basis …
How do you tell the difference between a normal pullback that will pass, versus a pullback that’s the start of a major collapse?
After all, if it’s normal volatility, you simply ride it out, staying focused on your long-term goals.
But if it’s the start of a major collapse, you’d want to sell. Sidestep the crash. And then, buy back in at massive discounts after the dust has settled.
Getting this call right can mean a retirement of travel, leisurely time with grandchildren, and pursuing fun hobbies. Getting it wrong can mean penny-pinching, budgeting, and perhaps even delaying retirement altogether.
So, how do you make the right decision?
It turns out, last week, Matt McCall and his colleague Keith Kaplan offered an answer. Today, let’s dig into it, and how it can make a powerful difference in your portfolio — and your peace of mind.
***A “one size fits all” approach doesn’t work with stocks
When it comes to protecting money from a plunging stock price, many investors use a “stop loss.”
Basically, the idea is that when a stock is sliding south, you’ll sell at some pre-appointed moment in order to avoid deeper losses.
There are many ways to do it, but the most common is a trailing percentage stop-loss. Something like “I’ll sell if my stock falls 20% below its most recent high.”
Now, this is Investing-101 and I’m certain you’re yawning at this point, so let me ask a more interesting question …
How do you know the right trailing stop-loss percentage to use?
Years ago, when I was learning about investing, I was taught “follow a 25% trailing stop.” This was presented to me as an ironclad rule. Not following it would be some form of investing heresy.
However, it wasn’t long before I noticed a gaping hole in the logic …
“25%” meant very different things to different stocks.
To a steady, slow-growth, utility stock, a 25% loss would be massive.
Yet, to a small, volatile biotech, a 25% drop could be nothing more than a hiccup before a monster 100% surge.
See for yourself …
Below we compare the percentage returns of utility company, Duke Energy, with biotech, CymaBay Therapeutics, over the last three years.
Given their radically different market-action, would it have made sense to apply the same stop-loss to them?
Looking more broadly, consider the many different market sectors and types of stocks available to investors. To name a few …
Large caps … small caps … biotechs … blue chips … utilities … tech stocks … gold miners … ETFs … solar companies … dividend stocks … REITs …
“Normal” market behavior for each of these groupings can be very different. And even within the same grouping, specific stocks can behave differently. Almost as if each one has its own fingerprint.
I recently read that the average American investor owns between 20-30 stocks.
Now, if they come from different sectors, and potentially have different unique “fingerprints” even within those sectors, would it make sense to apply the same blanket stop-loss to every holding in a portfolio?
***Last week, Matt and Keith held an event to discuss a tool called TradeStops, which is a proprietary trailing stop formula that’s customized to the unique fingerprint of each stock
It works on specific stocks as well as broad stock indices.
For example, in the most recent market crash from back in February, the system alerted Keith about a major market drop on February 27th.
But it turns out, the tool doesn’t only identify potential market weakness. It also picks up potential market strength.
After the above-warning signal, the system alerted Keith that markets were entering a rally period on March 27th.
Here’s how Keith recently described the tool:
What we’ve done is devise a system — based on numerous mathematical models — that helps you get out of the way of these big downturns before they happen and directly in front of the big upturns before they happen.
***How the system helps sidestep a common investing problem
Humans aren’t wired to be great investors. Unfortunately, that’s just the reality.
The research company, Dalbar, has documented this. In a long-term study that tracked investors from 1986 to 2015, Dalbar found that the average investor’s returns were just 3.66% per year, compared to the S&P 500’s annual return of 10.35%.
Why are we so bad?
It generally reduces to fear and greed. These emotions often cause us to do the exact wrong thing, at the exact wrong time.
Here’s how Keith recently described it:
People typically buy more of a stock as it goes down. The thought is because a stock was once at a certain price it will eventually return to that price …
The second mistake that people make is they sell a stock as it rises. They want to immediately lock in their gains. They take their money off the table too early because they think the stock can’t possibly go higher.
It doesn’t take a rocket scientist to realize that if we regularly hold onto stocks that are losing value, while quickly (and prematurely) selling stocks that have gained in value, that’s a losing proposition.
The TradeStop tool is intended to help investors recognize the difference between a stock that needs to be sold based on excessive volatility … versus a stock that should be held because it’s experiencing normal volatility.
But in both cases, the action-decision is based on the unique fingerprint of the specific stock.
The end result is that you sell losing stocks quicker and hold winning stocks longer.
***Boosting your portfolio gains without revamping your portfolio
The most interesting angle to this is how superior portfolio returns could come without tinkering with the portfolio holdings themselves.
In other words, you’re not having to replace all your stocks with a brand-new portfolio. Instead, you keep your existing stocks — but analyze each one on a unique level, within the parameters of its own volatility fingerprint.
Best of all, it removes emotion from the process because this is done based on cold, impartial numbers. You can avoid the stress and hand-wringing most investors face when wondering if they’re making the right buy/sell decision.
To learn more about TradeStops, you can watch the replay of the event with Matt and Keith by clicking here.
In any case, if you’ve been applying a blanket stop-loss to the individual stocks in your own portfolio — and worse, if you’ve been holding onto losers while selling winners — ask yourself how you’ll break these patterns today.
Doing so will likely make a world of difference in your portfolio.
Have a good evening,