I want to share a simple rule that has worked well for me over the years. I’ll explain the how and why, and then wrap up with some thoughts about when this rule might not be appropriate. So, imagine you are in a position, and then, for whatever reason, you know it’s right . In fact, it’s so right that it’s time to add to the position, and so you do. Now, think about what happens if the trade turns out to not be right, or to not develop as you expected – what do you do? Here’s the rule: if you add to an existing position and it does not work out as expected, you must get out of more than you added . Simple rule, but effective. To put numbers to the idea, say you are long 5,000 shares of a stock. As the trade moves in your favor, you get a signal to add to the trade (and that “signal” could cover many possibilities.) So, you add 2,000 shares. Somewhere down the road, the trade does not work out, and probably is under the price at which you added. Now, you know the right thing to do is to reduce the position size, and you must do so, but how much do you sell? Answer: more than 2,000, and probably more like 4,000 than 2,100. You now hold less than the original position size, and you’ve booked a loss on part of the position, but you’ve also reduced your risk on a trade that was not developing as you thought it might. One of the classic trading mistakes is to have on a winning trade, add inappropriately, and have that trade become a losing trade. For some traders, being aggressive and pressing when they have a good trade can add to the bottom line, but there is a tradeoff: when you become more aggressive you do so by taking more risk. The psychological swing – going from aggressive to wrong – can be one of the most challenging experiences for a trader, and many mistakes happen in this heightened emotional space. The rule of exiting more than you added is a simple rule, but it protects you from yourself. Now, no rule fits all styles of trading all the time. There could be styles of trading for which this is inappropriate, (for instance, when we add planning to scale in as the trade moves against the entry.) However, for “simple”, directional technical trading, this rule might be helpful in many cases. So much of the task of trading is just about avoiding errors and mistakes, and correct rules lead to good trading.
Can investors learn something from the SATs? It may be only a few more days to Christmas, but it’s also college application season. A lot of high-school seniors are filling out the Common App, writing and re-writing essays, and anxiously awaiting their latest test scores. And there’s a test-taking technique that kids use to improve how they do on standardized tests that can help investors. It’s elimination. When they come to a question to which they don’t know the answer, they can improve their scores by eliminating what is most clearly wrong. In a multiple-choice test, someone just filling in the circles gets 20 or 25% correct by random chance. But by eliminating the obviously wrong answers, students can better their odds. They won’t guess right every time, but they’ll do better than if they had left the answer blank. In the same way, investors can do better by eliminating what’s wrong. If a company’s business model makes no sense – if you can’t figure out how they earn their money – then don’t own that business. If management seems to be focused more on politics and celebrity than capital investment and HR, don’t buy the stock. This is a variant of The Loser’s Game by Charlie Ellis. We can be smart by avoiding dumb ideas. For example, in December of 2000, Enron employed 20,000 people and claimed revenues of over $100 billion. But some analysts started looking in depth at their derivative books and couldn’t figure out how the company was earning all their money. There was a gap between what was reported and what they could confirm. We know how this story ends: Enron filed for bankruptcy in December 2001. The executives used a willful, systematic, and intricately planned accounting fraud to inflate their earnings. (click to enlarge) Enron stock. Source: Bloomberg Investors would have improved their relative performance by avoiding Enron. That was difficult to do: the company was a media darling, considered a high-flying harbinger of the new economy. It had tremendous price momentum. But it was hard to see how they could turn 2% growth in utility revenues into consistent double-digit earnings growth for themselves. By looking under the hood – understanding the business, reading the financials – investors can sometimes avoid the big flops. And just like when kids take the SATs, if you can improve your odds – in a low-return world – that just might be enough.
By DailyAlts Staff Record-low interest rates and historically high stock valuations have more and more investors considering liquid alternative investments, which Goldman Sachs Asset Management (“GSAM”) defines as “daily liquid investment strategies” that seek to deliver “differentiated returns from those of core assets” and the potential to mitigate overall portfolio risk and severe drawdowns. In a recent Strategic Advisory Solutions white paper, GSAM makes the case for a multimanager approach to liquid alternative investing – through single turnkey multimanager funds, allocations across multiple managers of the investor’s choosing, or a combination of both. Why Diversify an Alternatives Allocation? GSAM categorizes the liquid alts universe into five peer groups: Equity long/short Event driven Relative value Tactical trade/macro Multistrategy As shown in the table below, the median returns of each peer group have very little persistence from year to year. Therefore, by diversifying across peer groups, investors can avoid the highs and lows of any given year in any given strategy. Building from Scratch One approach to diversifying across liquid alternative peer groups is to “weave” several liquid alts into a “unified portfolio construction framework.” This approach may be best for investors seeking to express high-conviction market views of their own, or for those who possess deep knowledge of particular strategies and managers. But in GSAM’s view, the process of selecting liquid alts requires expertise in the asset class, knowledge of manager capabilities, and judgment of manager and strategy risks, among other things. This makes the “build” approach research-intensive, which may be a bit much for many investors. Turnkey Solutions On the opposite end of the spectrum is the “turnkey” approach – a pre-assembled package of alts, such as a multimanager alternative mutual fund. In this approach, investors effectively outsource the research-intensive process cited above to professional managers. On the downside, investors employing this approach don’t get a customized allocation, which means that their specific investment needs could potentially be better-served. What are some other risks to the multialternative approach? GSAM lists several, including: Performance may depend on the ability of the investment advisor to select, oversee, and allocate funds to individual managers, whose styles may not always be complementary. Managers may underperform the market generally or underperform other investment managers that could have been selected instead. Some managers have little experience managing liquid alternative funds, which differ from private investment funds. Investors should be mindful of these and other risks, according to GSAM. The Best of Both Worlds? GSAM calls combining the “build from scratch” and “turkey” approaches “Buy & Build.” This hybrid approach generally entails complementing a multialternative fund with one or more high-conviction managers the investor believes can potentially contribute to specific investment objectives. This “middle ground” between pure customization and an off-the-shelf solution gives investors additional flexibility with a fraction of the research-intensity. Conclusion In conclusion, GSAM states the company’s belief that multimanager strategies have the potential to help investors pursue additional sources of returns and to diversify their alternative investment allocations. In the firm’s view, investors who are new to investing generally opt for the single package approach to multimanager investing, while more experienced liquid alternative investors often consider building from scratch. The important thing, in GSAM’s estimation, is to understand the potential that liquid alts offer as an additional driver of portfolio returns. For more information, download a pdf copy of the white paper . Jason Seagraves contributed to this article.