Trailing Stops, Whiplash, and the Best College Professor You Ever Had August 25, 2009March 15, 2017 GETTING ANGRY WITH SOME SENATORS If yours is one of the Senators standing in the way of health insurance reform – as all the Republicans are but a few Democrats are, too – watch Rachel Maddow and consider giving that senator the benefit of your views. HOW MUCH TO BET – II Yesterday, in discussing BZ and some other stuff you might have bet on “with money you can truly afford to lose” (hereafter, MYCTATL, or “play money”) – stuff that I hope at least partly made up for money you truly did lose on FMD and other idiot suggestions I’ve made here over the years – I realized that I’d not yet posted your further feedback on this general topic. (Remember our discussion of “The Kelly Formula?” That math wonks use to determine how much of their stash to bet on any particular horse?) So here goes: Sarah Johnson: “I’m one of those with nothing to ‘play’ with. And, when I someday do get something to ‘play’ with, I think I’m far more likely to gamble on art or on helping to finance a movie…at least that way I’ll get something interesting to look at or live with. That Kelly theory only would work if we had bookies who gave us real odds for stock picks. Wow. I’m no slouch at math (I’m a civil engineer), but I have a hard time applying that theory to the stock market. I’m not surprised you needed an Advil. Maybe it should be swallowed with a stiff drink, too.” Charlie Mac: “How to define ‘money you can afford to lose’? I recall from my absolute favorite finance book over the last 25-plus years, these guidelines (some from the author, some from me). Invest/Gamble only AFTER: All credit cards are paid in full, AND no plans for using credit in the near future (that vacation to Hawaii coming up will be paid in full by cash on hand, right?) IRA/401k’s maxed out, and a general plan for retirement in place and funded Long-term disability insurance in place (you are 3x more likely to be disabled than die during your working life, so yeah, it costs more than term life insurance) Health Insurance coverage (kind of a hot topic these days) Adequate term life insurance in place (only if there are people you care about dependent on your continued income) Homeowners/Renters/Flood insurance: I think my parents were the only people on the Mississippi Gulf Coast with Federal Flood Insurance. Cost them $50 a month, and they were made ‘whole’ after Katrina. They were not in a ‘named’ flood plain, but I would deem the entire Gulf/East Coasts as flood plains. Emergency fund in FDIC insured savings account – 6-12 months worth (or more), depending on how difficult you think it would be to get a new job in your particular skill set. Also covers unanticipated auto/home repairs. Emergency food/water supply: Depends on how paranoid you are. FEMA says everyone should be able to get along on their own for 3-7 days. What if Swine flu hits your town hard, would you like to be able to ‘hole up’ in your house for 30 days? Just throwing it out there. Did I miss anything? Doesn’t leave a lot for crap shoot investments, as you have always warned.” ☞ Close enough. But I do hope you have 100 shares of Borealis like everybody else. (Misery loves company?) Geo Hamlett: “You write, ‘But if I were 60 and had built a $250,000 kitty of play money, I certainly wouldn’t put more than a fifth of it into any one thing – and generally nowhere near even that much.’ Buffett is reputed to have said the first rule of investing is not to lose money. And the second rule is, see Rule Number One. A simple yet effective way to attempt that is to use position sizing and trailing stops. An example of that would be to use a 4% position in each buy, which would allow for 25 positions. Combined with a 25% trailing stop, the maximum loss in any one position is 1% of the total portfolio (25% of 4%). The same could be accomplished with any combination of positions and position sizes. Fifty positions, 2% size, 50% trailing stop. Ten positions, 10% size, 10% trailing stop. If you’re willing to take an overall 2% loss in any position, you can adjust the trailing stop. It’s not a bad rule of thumb to trigger a sell of a losing position, which seems to be a difficult thing for most people to do. And to me at least, it certainly seems better that trying to ‘feel’ your way. Not GPS maybe, but at least a roadmap.” ☞ There’s a lot of good sense in that comment. Let me add a few thoughts. First, on position size, I think holding 25 or 50 positions in your play money account is more than is practical for most people. Remember, we’re not talking about prudence or capital preservation here – as we would be with money you can’t truly afford to lose. We’re talking about a smallish carve-out some people may be able to set aside, with perhaps three goals: first, a shot at a big score (hey, it can happen); second, a little fun and excitement that likely beats the same money blown on a trip to Las Vegas or lottery tickets (let alone cigarettes or a speedboat); third, the chance for tax control – this notion I keep mentioning of “coming out ahead” even if you only breakeven by using your losses to knock $3,000 off your taxable income in some years, but using your long-term gains, if any, to fund your charitable giving (and/or just take advantage of the lower capital gains tax rate). So having four or five such bets working at any given time – wildly imprudent with your “real” money – could be just fine with MYCTATL. Second, on trailing stops, the first thing to say is that, yes, they can provide a good discipline. And they’re certainly more convenient than trying to remember to check the market constantly to sell a position that’s going against you. At Ameritrade, for example, you just select “Trailing Stop %” from the Order Type menu when you place your buy order and enter the % by which you want it to trail behind. It’s like a ratchet – the stop loss price rises if and as the stock rises; but it never falls, if and as the stock falls. So maybe you bought the stock at $22 with a 10% trailing stop but it rises to $30, so the stop is now $27 – 10% below $30 – and if the stock does fall to $27, out it goes. But be aware there’s no guarantee you’ll be protected just because you set a 25% trailing stop (say). Perhaps you bet on a drug stock because you think the FDA will approve its one and only product-in-development but – oh, no! – the FDA rules the other way. That stock could drop from $22 to $6 in a single trade (as there would be no buyers on this news and a zillion sellers, not least those who had placed trailing stops). An extreme example, but still. A more typical problem is “whiplash.” Sometimes, a stock’s drifting lower is the market, in its wisdom, telling you something valuable: the smart money (or at least smarter than you) is getting out. Don’t fight it; get out, too. That’s the upside of this discipline. It can save you a lot of money. But what if the stock drifts lower simply because the market as a whole is drifting lower? Or because a rumor that proves false tanks the stock? Or because someone who owns 400,000 shares of a relatively illiquid stock finds he has to sell it in a hurry because he needs to rescue his brother from narco-trafficking kidnappers? In that case, the stock dips to your trigger and you’re out – but might bounce right back up even the next day. You could buy it back of course, but if you keep buying it when it bounces higher and selling it when it dips lower – well, with hindsight, at least, you would know you “set your stops too tight.” Let me stop this part of the discussion here, because we are at risk of getting interested in trading strategies, and – like that first line of cocaine, or that first game of pool in River City – that is the first step on the road to day trading and almost sure ruin. (I exaggerate; but not entirely. A pool table! And the next thing you know . . .) Chris Brown: “Re the Kelly formula . . . William Poundstone’s Fortune’s Formula: The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street is a GREAT read which touches upon the Kelly formula, although it is largely about Edward Thorp. I can’t do this book justice, but David Pogue writes in his review for the NYT Book Review: “Fortune’s Formula may be the world’s first history book, gambling primer, mathematics text, economics manual, personal finance guide, and joke book in a single volume. Poundstone comes across like the best college professor you ever had, someone who can turn almost any technical topic into an entertaining and zesty lecture.”