New traders are taking on huge risk … how to gamble wisely … the numbers behind safe speculations
In recent months, the number of small guys in the market (like you and me) has exploded 150%.
Last year, retail investors accounted for 10% of market activity. In the wake of the late-March low, that percentage has climbed as high as 25%.
Add to that a new Yahoo Finance-Harris poll from Wednesday finding that “43% of retail investors said they are using options, margin, or both.”
Now, we don’t have a problem with options — as long as you use them responsibly and are aware of the inherent risks. Some of our most successful analysts regularly use options in their newsletters to generate triple-digit returns.
But we doubt the majority of these newbie investors fully understand options. Case in point, the recent, tragic story of the 20-year-old day-trader who committed suicide after seeing what he believed were massive losses from options-trading in his Robinhood brokerage platform.
As to margin, we believe this is a tool best left to the professionals when it comes to stocks.
For readers less familiar, margin is money borrowed from a brokerage firm (in this case, by a retail investor) to purchase an investment.
If your trade goes as hoped, margin is a powerful way to juice returns. Like kerosene on a fire.
Of course, if things don’t go your way, margin is an express train to financial ruin. After all, you’re losing money you didn’t have to begin with.
Given this, we find it troubling to learn there’s an explosion of new, inexperienced retail traders in the market, and almost half of them are using risky financial tools.
Here’s Yahoo Finance! with more details:
The survey’s high options numbers echoed other evidence that we’re in an options boom.
In 2020 so far, there has been an average of 28 million options contracts per day, up 45% from last year, according to the Options Clearing Corp …
… just under half (44%) of the survey respondents said they have been trying to time the market …
And for those investors actively trying to take advantage of the market’s moves, the average number of trades per month is 4.5.
And don’t make the mistake of believing these traders are middle-to-upper-income earners who can easily absorb market losses.
The survey shows that the group making the most trades are those with household income of less than $50,000.
***What these newer investors don’t realize is shooting for huge returns doesn’t have to come with equally-huge risk
In Wednesday’s Digest, we shared with readers a surefire way to transform your long-term gains.
We did this through profiling The Risk Vs Reward Manifesto — a powerful e-book from our CEO, Brian Hunt.
From Brian’s Manifesto:
How you manage Risk Vs. Reward — how much money you risk on investments, short-term trades, and business deals relative to how much money they can make you — determines the long-term success of everyone in business or the markets.
I’m willing to bet that the overwhelming majority of these new traders, leveraging up and using options, have no idea how much risk they’re taking on. Instead, they only have dollar signs in their eyes.
As Brian notes, this is usually a way to suffer big losses:
… the way most think about Risk Vs. Reward is ALL WRONG …
Most people spend 100% of their time as an investor thinking about how much they can win … which is why they lose …
They don’t think for a second about how much they stand to lose if things don’t work out as planned or if the best-case scenario doesn’t play out.
***In the rest of this Digest, let’s look at one approach to swinging for the fences, without taking on too much risk
We’re going to combine three elements:
- A small sector of the stock market that offers investors “asymmetric bets”
- Proper asset allocation
- A “venture capital” portfolio approach with strategic position-sizing
For the first element, here’s Brian from his Manifesto to explain:
Expert investors and speculators seek asymmetry in virtually all the positions they take.
An asymmetric “bet” is when the potential upside of a position is much greater than its potential downside.
If you risk $5,000 for the chance of making $100,000, you make an asymmetrical bet.
So, where do we find stocks that might be capable of climbing hundreds or thousands of percent?
Well, InvestorPlace actually has a newsletter dedicated to this exact goal.
It’s called The Daily 10X Stock Report, and it’s engineered for one sole purpose:
Delivered to your inbox — every day the market is open — a top-notch small-cap stock pick that could rise by 1,000% or more in the long run.
The service launched in mid-May. As to how well it’s holding up to its goal of finding 10X-returning stocks, here’s Luke Lango from the 10X-Monday-update to subscribers:
In just three full months of issues, we’ve had (in terms of max returns):
- 55 stocks rise more than 10%
- 45 stocks rise more than 20%
- 23 stocks rise more than 50%
- 8 stocks rise more than 100%
- 3 stocks rise more than 200%
- 2 STOCKS RISE MORE THAN 400%
So, element number-one — stocks that have the potential to provide us an asymmetric reward?
I think it’s fair to say “check.”
***The second element is proper asset allocation
Back to Brian’s Manifesto:
Asset allocation is the part of your investment strategy that dictates how much of your money you place in broad asset classes like stocks, bonds, cash, cryptocurrencies, precious metals, and real estate.
Whatever asset allocation mix you choose, just make sure you’re not at risk of being wiped out by a crash in a single business or asset class.
Asset allocation also works within a specific asset class.
For example, while most of your stock portfolio might be allocated to blue chips, a second chunk might be in income-producing stocks. And a smaller portion could be allocated to these 10X “swing-for-the-fences” stocks.
You might decide that, say, a 10% allocation to these high-fliers would be reasonable (out of your entire stock allocation). That percentage could be higher or lower based on your specific financial situation and risk/reward temperament.
But in general, the benefit of a smaller allocation is that if things don’t work out as hoped, it won’t cripple your total investment capital.
This brings us to the third element of the game-plan — a venture capital “portfolio” approach with wise position-sizing.
Basically, this final step answers the question “within our 10% allocation to these potential 10X winners, how big should each stock position be, and why?”
***It just takes one huge winner to transform a portfolio
The 10X service provides subscribers an Education Center, containing a series of insightful essays.
From one of those essays:
… it’s helpful to approach the companies we recommend in the Daily 10X with a “VC mindset.”
Venture capitalists know that investments in small companies have huge upside.
These investments can skyrocket 10-fold, 20-fold, even 100-fold in value.
However, venture capital investments also carry higher risks than investments in larger, more established companies …
So, venture capitalists lose money on their investments more often than they make money. Their “win rates” are lower than investors who stick to big blue-chip stocks. It’s a risk/reward tradeoff …
Sure, a lot of the investments won’t be successful. But the ones that are successful are successful in a very big way.
One jumbo 3,000%+ winner like Netflix more than makes up for a lot of small losses.
So, we want to think of these 10X-potential stocks as one holistic portfolio like a venture capitalist might.
How many stocks should be in this portfolio?
In Brian’s Manifesto, he details position-sizing, writing “most world-class investors say to never put more than 10% of your portfolio into any one position.
Given this, while you could add more stocks (which would lower the size of each position), let’s make it easy and say 10 stocks, each with a 10% weighing.
Now, let’s look at some outcomes …
***All losers except one big winner is still quite a payday
The 10X material above references a jumbo 3,000% winner like Netflix.
Given that Luke has already dug up 2 stocks that have risen more than 400% in just three months (and eight that have risen more than 100%), I believe the odds of hitting a 3,000% winner are reasonable enough to use in a hypothetical.
Let’s say that nine of your 10 stocks lose everything — keep in mind, that’s a -100% return rather than just a 0% return.
However, let’s also say that your tenth stock is a 30X winner.
The composite return of your entire 10X sub-portfolio is 210%.
Again, that’s with a complete loss of capital on nine out of 10 positions.
That’s the power of just one big winner.
Now, let’s be incredibly pessimistic.
Let’s assume that the 10X-team’s incredible returns so far are a fluke. It turns out five of his picks lose everything — again, that’s -100%. The other five go nowhere, for a 0% return.
Altogether, that’s a -50% return on this 10X sub-portfolio.
But if your 10X sub-portfolio was just 10% of your overall stock portfolio (based on the wise asset allocation we described above), then this basket of -50% losers only pulls down your overall stock portfolio return by 5%.
Compare that to the newbie trader who risks, say, 25% of his entire investment capital on a single stock, using options and leverage.
If he encounters the type of losses we just profiled, it won’t mean a 5% cumulative loss. It’ll likely be complete financial devastation.
Bottom line — when you combine high-flying small caps like those in The Daily 10X Stock Report, proper asset allocation, and wise position-sizing, you get a reasonable way to swing for the fences, all while protecting yourself if you don’t hit that homerun.
Remember, protecting the money you already have is your number-one job as an investor.
Have a good evening,
Jeff Remsburg
