Sell strategies are necessary, but they're not perfect. They can save you from enormous losses, but like any strategy, they have their pros and cons.
The previous chapter showed you one of the disadvantages. You can't just set up a sell strategy and forget all about it. You need to keep an eye on the market and the news, so that you can override your sell strategy if a drop is event driven.
Sell strategies can also produce “false alarms,” that is, they will occasionally predict a bear market that does not happen. During a false alarm, the market goes down, crosses underneath its moving average, and triggers a sell. Then it bounces back quickly (an event-driven drop, perhaps), crosses above its moving average, and prompts a buy. When this occurs, you miss out on any gains you could have had from rising stocks because you sold before the rebound.
The reverse scenario can cost you, too. If the market rises quickly and triggers a buy, then drops enough that it goes below your sell point, your buy will be higher than your sell, and you will have lost money in that trade. You'll have been whipsawed.
I view those two disadvantages as small worries. If you make less than you might have, that's okay in my book because I believe the reason to use a sell strategy is to avoid massive losses in bear markets, especially ones like those that occurred in 1929, 1974, 2000, and 2008. I consider the fact that you don't perform as well when this happens as the insurance premium you pay to protect your principal against very large losses.
I believe it is also okay to lose money in a trade like I described above. There is no strategy that never loses. You have to consider the least of the evils: which strategy could cost you more? In the whipsaw transaction I described, your losses would not be as significant as they would be if you clung to buy-hold during a bear market.
My firm, Money Matters, had a false alarm in 2010. The financial environment was grim: The BP oil spill jeopardized the economy of the entire Gulf coast. Europe's economy was on the verge of collapse. The debt ceiling debate threatened to bankrupt America. If any one of those events had happened, we would have seen a full-blown bear market. The risk was enormous. We advised clients and the listeners of my radio show to get out of the market. As it turned out, none of those potential catastrophes occurred. The BP oil spill was manageable, the European crisis passed, the debt ceiling was raised, and all was well. Then the market rebounded and we missed the returns we could have made. Granted, that wasn't good. But the downside risk was so great that it was more important to protect principal than to worry about whether or not the sell was a false alarm. Investors avoided the bigger evil of a potentially life-changing loss.
On the flight back from a financial conference in 2009, I sat next to a young man from Oklahoma. When he asked me what I did for a living, I told him I was a financial advisor. “Wow, 2008 must've been really rough for you,” he said.
“It wasn't so bad,” I replied, “because we advised our clients to be in cash for that entire year.”
“How did you do that?”
“Well, we have what we call a ‘sell strategy,’ ” I said. “We hit our trigger at the end of 2007, so at that time we advised our clients to sell all of their stocks.”
Being from Oklahoma, he quickly related it to a danger he and his family face every year. “So it's like a tornado warning for your investments,” he said.
I thought about it for a moment. “Yes, exactly. So tell me, what do you guys do in Oklahoma when you hear the tornado warning going off?”
“We go down into the storm shelter,” he said.
“What happens if the tornado doesn't hit you?”
“I guess we had a nice game of cards.”
“What do you do if the siren goes off a second time?” I asked.
“We go right back into the tornado shelter.”
“And if the tornado misses you again?”
“Then I guess we played some more cards.”
“How many false alarms would it take before you decided to ignore the alarm?” I asked.
“It doesn't matter how many false alarms there are,” he answered. “I will take my family into the storm shelter every single time because I cannot afford to be wrong once.”
It's the same with your sell strategy. Don't be afraid to take your money into the tornado shelter as many times as the siren sounds. While false alarms may reduce your returns, when that financial tornado does hit, you will be very glad you're sitting nice and safe in cash.
Remember Jeremy Siegel's 1 percent band? He put an up-and-down tolerance around his 200-day moving average to help minimize transaction costs. A properly designed sell strategy will similarly limit the number of times you have to buy and sell, so transaction costs should not be significant. But even though you've minimized the costs, you may be tempted to hold on to an investment just because you don't want a transaction cost. Don't fall for that. If the situation becomes another 2008, you could lose 57 percent of your money just to avoid that cost. Not a good trade-off.
Taxes are a similar issue. No one likes to pay taxes, but they are a necessary evil. To be a successful investor, you will have to take profits when the time is right to sell. By doing so, you will create a taxable event. It's okay. You can't let the tax tail wag the investment dog. You have to keep your eye on your highest priority: protecting your principal.
A prospective client told me this story in 2002: “I bought Qualcomm in January 1998. I put $10,000 into it, and watched it go up. By December 1999 it had gone up 2,900 percent. My $10,000 was now $303,000!
“In 2000, Qualcomm started to go down. When it hit $260,000, I thought to myself, ‘If I sell this now, I could pay off my mortgage and my car. I'd be debt-free and a long way toward retiring.’ But I didn't sell. You know why? Because I didn't want to pay the taxes. I just didn't want to pay the capital gains taxes.
“So I rode it down. I finally panicked and sold my Qualcomm stock in January 2002, when it had dropped 73 percent from its peak. That $303,000 I had became $80,000.
“Normally, if you invest $10,000 and you sell it four years later for $80,000, you feel like you made a really good investment. But when I think that I had $303,000 and I didn't capture that, it makes me sick to my stomach.”
I hope you can learn from that poor guy. Don't put avoiding paying taxes ahead of taking care of your investments. Don't put anything ahead of preserving your principal. Instead, put the odds in your favor.
Las Vegas does it. The casinos know that somebody is going to walk in the door, plug a dollar into Big Bertha, and win $1 million. The casino will lose big on that lucky gambler. But they also know that a million not-so-lucky gamblers will lose way more than that to Big Bertha. The casinos have made sure the odds are in their favor.
I believe sell strategies are your best chance for not losing because, like the Vegas odds, they are based on mathematics. I have every confidence that the sell strategies I have outlined in this book should help protect you from bear markets in the future. The mathematical certainty gives me confidence, and it can put the odds in your favor.
Remember, I'm not talking about the odds of winning big. I'm talking about the odds of keeping the investments you need to live out your retirement years. Investors tend to be obsessed with maximizing returns and getting the highest possible returns at all times. To get these kinds of profits, investors often take more risk than is necessary.
If you are a prudent investor with a sell strategy, you will probably go through periods of time when you wish you were making more. You'll see that the market is doing better than your portfolio, and you'll wonder if you should be chasing some of those fabulous returns. You may have some regrets about your slow, steady course. Take solace. It is the right thing to do. When the next bear market comes along and blood is running in the streets, you'll be sitting comfortably in cash. Don't forget the fable of the tortoise and the hare. The hare was incredibly fast and very exciting, while the tortoise just plodded along, but who won the race in the long run?
Sell strategies help you avoid the worst-case scenario. Yes, they come with false alarms. They could cause you to underperform. They may cause you to lose money on the whipsaw. As I see it, those are much smaller costs than losing massive amounts of money in a bear market.