Money Management
The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to ensure that as few as possible escaped the common misfortune. The fortu-nate speculator who had funds to answer the first margin call presently got another and equally urgent one, and if he met that there would still be another. In the end all the money he had was extracted from him and lost.
—JOHN KENNETH GALBRAITH, The Great Crash 1929
Selling is survival in the stock market. In the world of trend following, the term money management refers to your strategy for minimizing your risks and maximizing your gains. Financial glory is not in finding trends; it is in selling losers and riding winners. You buy a stock, hopefully one that meets the criteria I have outlined, you shut out the noise of the day-to-day flow of information, and you hang on until price takes you out. As a framework for the chapter, take a look at the two charts below. They were created by Eric Crittenden of Blackstar Funds. The first looks at compounded annual returns of individual stocks from 1983 to 2006:
The second chart looks at delisted stocks:
The key takeaway is that picking stock winners is extremely difficult. The like-lihood of holding them makes investing more difficult, and since 33 percent end near zero, investors are really getting stuck a good percentage of the time. From the second chart you see that the strong get stronger and the weak get weaker. The money moves in and out of stocks and trends in big waves, for the most part.
Averaging Down: Dude, It’s Cheaper
At the beginning of my hedge-fund and trading career, averaging down was something I heard and read everywhere. I wish I had been introduced to a mentor or trading blog that never preached the term. When you watch financial news all day, you will see mutual-fund and hedge-fund managers spew the mantra, The market is down; it’s a better time to get in. I do believe there is a connection between prices dropping and stocks becoming cheaper, but stocks are just pieces of paper and who is to say what the ultimate cheap price is, or how long it will take for the rest of the world to agree with you? For the average investor, if you want to buy individual stocks, averaging down is wrong. If 33 percent of stocks head to zero, averaging down into just one in your career can be devastating—financially and mentally. Take a look at WorldCom, Enron, and, an even more recent example, Krispy Kreme Doughnuts.
Krispy Kreme
Does Timing Matter?
Focus on buying stocks at the right time—as they emerge from sideways price action. The longer the better. You can’t own every stock, therefore you should concentrate on the companies and setups you feel are best. You won’t get this feel overnight. You can look at hundreds of past winners, as most long-term charts look the same. You need to be like a great hitter who takes walks while waiting for his pitch. The stock market will provide you with more and more pitches for your whole life. You only need to hit a handful out of the park to make investing a profitable and enjoyable experience.
That’s the good news. Here’s the bad news: No matter how good your entries and how great the market is acting, many times you are going to be flat-out wrong. Whether you work at it twenty-four hours a day or five minutes a day, there are periods when stocks just act nasty. They fake you out and suck you in at the precisely wrong time. The losers will come from the same list you are looking at for winners (I delve deeper into surviving in Chapter 6).
Your best defense is to avoid averaging down and to practice disciplined buy tactics. Strong trending upward markets and stocks at or near all-time highs from long bases are the best, and if you practice, over time you will thrive. I love this quote from Jesse Livermore in my favorite stock market book, Reminiscences of a Stock Operator:
I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat showed me a profit and I sold it out. Of all the speculative blunders there are few greater than trying to average a losing game.
When Markets Are Good, Pounce!
After reading the first half of this book, you should be tempted to invest money in individual stocks. But the first thing you need to do is refrain from investing your money immediately. Instead, look at the all-time-high lists for a month or two in order to get accustomed to the market strength and price action. You need context, as I said in Chapter 4. There is no rush, no need to tell yourself, Oh, my God, I read the first four chapters and I get it. I’m going to look at the all-time-high list tomorrow and pick ten stocks. Wrong.
You will get a feel for the list within a couple of weeks. Then watch it for two more weeks just to be sure. Then try to find some companies you relate to. If there are hundreds of companies showing up on the all-time-high list, it is likely a good time to invest. If there are only ten or twenty, and that seems to be persisting, there is no rush. It means that the market sucks, at least for us trend followers. The reason you have to watch the list for at least a little while is to put the all-time-high list into some sort of context. Is it expanding? Declining? The more stocks you see at all-time highs, the better feel you will get for the strength of the market. That context is critical.
Take a refresher look at the long-term chart of the S&P the next time you are worried that the market will not go higher or that you feel you have to buy stocks tomorrow or you will miss the proverbial boat. Do less, watch more, and wait for great markets. When hundreds, or even thousands, of stocks are hitting all-time highs, you will make more money than you can imagine by simply riding positive trends.
Fishermen sit all day, and sometimes for weeks, waiting for the chance to reel in the big lunker. I like fishing and want to catch fish, but I am not in the business of chumming. Sure, if I go fishing for an afternoon I want to catch fish, and I even get the urge to chum, but trust me, patience pays off. You will have plenty of investing years.
Let’s say that the time comes when you say to yourself: You know what? This market has hundreds of stocks breaking to all-time highs. I’m going to own stocks. If you’re going to do that, try to stick to ten or twenty stocks you have a real-world connection with. Stick to stocks whose prices have been going sideways the longest and are now just hitting all-time highs. If you want to buy a stock that has been going straight up for two years, understand that it is a different risk than a stock that is just breaking out of going sideways. Stocks that have risen for longer periods of time with little sideways action are prone to rapid and deep bouts of selling.
The next thing you need to do is place an order. The hard part at this point is deciding how much money you want to invest. You need a complete game plan: what’s the total portfolio size to invest, how many stocks, how much risk to take. If you want to invest ten thousand dollars and you want to follow twenty stocks, that would be five hundred dollars per stock. Think also about the commissions you will pay. Then you have to decide if you want to ease into it or just plunge in. I don’t think that matters. If you have been patient and the market is strong and your setup is strong, you can plunge. If you decide to buy, what next?
Commissions
Most individual-investor portfolios need only a simple stock account. I use a company called Interactive Brokers (NASDAQ: IBKR) for my hedge fund. There are so many online brokerages to choose from. I have not had experience with any of the following companies, but the people from my blogroll whom I trust use:
thinkorswim—Investools (NASDAQ: SWIM)
OptionsXpress—(NASD: OXPS)
Charles Schwab—(NYSE: SCH)
You will have to find the right online broker who fits your needs for customer service and cost. I say take the time to learn the ins and outs of online brokers and the Internet so you can get the best execution at the lowest commission rates.
The Golden Rule of Trend Following or Any Investment Strategy Is Simple: Survive
Live to invest another day. There is no coming back from big blow-ups, and trend following has risks. Every success stems from being in the game. Anyone who cannot put that rule first needs a different book. There is no perfect way to ride a trend or to get off it, because they mean different things to different people. Riding trends and getting off them is a style and risk-management decision. I cannot possibly know such things as your financial goals and objectives or how much risk you are able to take. I do know that you can be a successful trend follower if you follow certain principles about buying and selling stocks and if you learn to spot opportunities.
If you are managing money properly, it doesn’t matter what the overall market is doing. Even when the Nikkei index for the Tokyo Stock Exchange fell 65 percent between 1989 and 1992, there were certain stocks that went up, and there were ways to make money. A crash like Japan’s occurred in the United States’ markets after the dot-com boom in the late 1990s and early 2000s. If you were using proper money management at the time, your leading stocks were stopped out and your money would have flowed into real estate and commodity stocks as they emerged to all-time highs.
If you are managing money properly, you don’t have to worry about a potential Enron in your portfolio because you will be out of any disaster like that well before it happens. Enron made greed and pop-culture news because its executives stole from the company. Unless you worked there or were not following sound money-management principles, it would not have taken you out of the investing business.
What Is Your Risk Tolerance?
Reducing your risk and maximizing your gains involves answering questions that only you can answer. Questions such as:
How much of my money should go into stocks?
• How much of my money should go into different stock ideas?
• How much am I willing to lose on each stock?
• What is my time horizon?
There are no hard-and-fast rules. You need to set your own boundaries. Just don’t lie to yourself. Investing is not a game. Assume that you will do everything wrong as an investor and ask, What is the most money I am willing to lose? The answer to this question is the total amount you should invest in stocks, and this amount should be divided by the total number of stocks you are willing to invest in and follow. It is your money, so be careful.
Here are two extreme examples. If you are twenty-five years old and serious about investing, you might decide that you want thirty years to invest. In a strong market you can be more aggressive. On the other hand, don’t rely on trend following if your son is going into his senior year in high school and you are wondering how to pay his college tuition. The more time you have, the more opportunity there is for success. Less time means less opportunity.
I am in my early forties and am fortunate to have had some success. I have reliable income. I allocate a lot of my liquid or investable money in stocks because I think I have a very good grasp of what I am doing. I also am more focused on strategy and have survived many heartaches. I trust my ability to manage a certain number of stocks. At any one time I might have as much as 40 or 50 percent of that money in stocks. At the other extreme, I have rarely held less than 10 percent of my investable assets in stocks. Investors in their seventies might want a 10 or 20 percent stock allocation because they may be focused more on income than I am. A person with less experience than I have might have less money in stocks.
So my response to all of the questions above is, What can you live with? I am not going to highlight just one diversification strategy. That’s because I believe that the strategy that will work best for you is the strategy you create based on the boundaries you can live with. In order to help you think about your own strategy, I will give a brief history of how my own strategy emerged and how it now works.
A Little History
In 2001, two of my friends, Cole Wilcox and Eric Crittenden, who worked for my hedge fund at that time, set out to further research investment strategies. The market had taken a serious dive and none of us was in the mood to talk about stocks. They did a lot of research, trying to discover different ways to look at entries, exits, trades, and just about everything else. We were all looking for a profit-able way to manage money, and we all became enamored with trend following.
Cole and Eric began the long process of applying the trend- following systems of successful managed-futures managers to stocks. Their research, completed in 2005 (www.blackstarfunds.com), looked back at twenty-four thousand stocks over twenty-two years to test a trend-following formula. That formula involved buying a stock at the opening price on the day after it hit an all-time high, and then selling it at a ten-unit average true range (ATR) trailing stop. A trailing stop is an order to sell a stock at a price determined by a mathematical formula that adjusts the selling price in order to allow profits to run while limiting losses (the details of setting an ATR training stop are explained later in this chapter). Cole and Eric concluded that “buying stocks at new all-time highs and exiting them after they’ve fallen below a 10 ATR trailing stop would have yielded a significant return on average.” Armed with this research, they were comfortable answering the question, Does trend following work on stocks? with, The evidence strongly suggests that it does.
Blackstar Fund, launched by Cole and Eric, is based on their research. I was an early believer, putting some money where my mouth was and becoming an early limited partner. I got an inside look at what they were building, how they managed positions, and how they built systems. It all made intuitive sense to me, and I started blogging and talking about trend following. What is in motion tends to stay in motion, in either direction. I learned that a signal to buy is a signal to buy. They look the same in every market.
Sell Is Not a Dirty Word
With the stocks you buy, you will be looking for long-term gains, not short-term gains. On the way to long-term gains, there will be a lot of losses. Using Blackstar’s strategy, there would have been more that eighteen thousand trades during the twenty-two years they examined. Forty-nine percent of those trades would have been profitable. That might not seem impressive at first glance, but the use of trailing stop-loss orders would have limited losses while letting profits run, resulting in significantly larger gains for the winners than losses for the losers.
So you can make money being right 49 percent of the time if you have the ability to stop small losses from become big losses. If you cannot take those small losses time and time again, then trend following—and most likely the stock market—is not for you. If you cannot sell a stock because you are too attached to it or you are convinced it will turn around and come back to profitability, then the one time you are wrong you could have an Enron on your hands. That kind of loss can do a lot of financial damage, and it is very hard to come back from a major investment disaster.
From the moment you buy a stock, you have to be committed to selling it. Selling is the most important part of money management, and it’s the place where people most often slip up. You must trust in a system like Blackstar’s or you have to set some very good boundaries for yourself. Exits are essential to any trend strategy. You set boundaries for buying—stick to all-time highs and stocks and companies with catalysts—now you have to set boundaries for selling. Decide at the beginning, when you buy, This is how much I’m willing to lose on that stock. That takes a lot of the mystery and anxiety out of selling because you have a plan.
Sell When You Can, Not When You Have To
Remember this: All stock trends end. All of them. Some on their own, some because of bad management, and some sooner than most because of competition, technology, or an unforeseeable change in market conditions. If the company does not screw it up, Wall Street will. Eventually, as I have written earlier, they will create enough stock to satisfy demand and more. That supply always comes back to haunt companies, and it usually occurs as they slow.
So little time is spent on money management and even less on selling as a part of it. Selling is part art, part luck, and part discipline, but of the three, discipline is most important. Why is selling so important and, more importantly, why is it so hard?
When you buy a stock, consider it a privilege, not a right. You are in control until you push the Buy button. After you push Buy, the markets are in control. Your only remaining control is the Sell button. Of course you can buy more, but if you do your work right, you should be buying more only at higher prices. Just as there is no perfect strategy for minimizing your losses, there is also none for maximizing your gains. I use a very simple strategy: If a stock rises a quick 30 or 40 percent, or sometimes even 20 percent, I start selling. I tell myself, A profit is a profit. Take it. I want that positive enforcement. I have thought about taxes long ago, when I decided to be a trend follower. Each buy is made with the goal of it being a long-term capital gain, but if it moves quickly I am not afraid of paying taxes on a short-term gain.
Get used to taking profits by selling pieces of your winners and constantly re-adjusting how much money you are willing to lose. Blackstar and other systematic traders would argue that this is a science, and I would agree with them if you are investing money professionally. But if you want to do this for yourself, it becomes more a question of your own boundaries. The key is to ride the trend, and you ride it by selling on the way up and giving it a wider and wider berth to really perform longer term. The best way to ride a trend is to have sold enough on the way up that you can feel comfortable knowing it might be really wild for the next five years and you can give it the room to be wild.
Trending stocks are generally more volatile. They are in the news more and as the trend persists, as they get followed and are owned by more institutions. You will learn to give certain stocks the wider berth they need. They are like kids; you have to give them room to grow and room to make mistakes. You might also learn to tell yourself, You know what? I have a $10,000 portfolio. I think I only want to put $300 in Google, because it’s wilder than the rest.
You do not have to check in on your stocks once a day, or even every other day. You should be aware of when your companies are reporting their earnings. That is not a lot of work. Use Internet tools to have the information you want to see deliv-ered to your inbox, as I discussed earlier. You must be honest about your risk profile. To catch winners, the ones that make a huge difference to your portfolio returns, you can’t sell all your winners when they move 20 percent in your favor. To own stocks, you will also endure losses and inconsistent returns.
Exits and Stops
I use trailing stop-loss orders, which are instructions to sell stocks when they fall to a certain price. There are different kinds of trailing stop-loss orders. Blackstar uses ATR stops, which they define in this way:
The average true range (ATR) . . . measures the daily movement of a se-curity by calculating the greater of:
• Today’s high minus today’s low
• Today’s high minus yesterday’s close
• Yesterday’s close minus today’s low
The ATR illustrates the maximum distance the security’s price trav-eled between the close of one business day to the close of the next business day, capturing overnight gaps and intraday price swings. There are free computer pro-grams online that will help you find the ATR of any stock on any day. The ATR shows the number of cents a stock’s price went up or down on average over a certain period of days. For example, on November 2, 2007, Apple’s closing price was $187.87. Its ATR for the previous seven days was 4.94, meaning that the price went up or down on average $4.94 over that time. When Cole and Eric say that they employed a 10 ATR, they mean that they multiplied the ATR by ten, and then subtracted the result from the stock’s price in order to arrive at their stop-order price. If you had bought one share of Apple at $187.87 on that date, and if you had followed Cole’s and Eric’s method, you would set your stop using this formula:
Purchase Price—10 ATR = Exit Price
187.87—(10 x 4.94) = 138.47
An ATR stop accounts for the typical movement of a stock. Every stock has its own movement. As I write this, Google moves a lot more during any particular day than General Electric, so Google needs a wider price berth than General Electric. You likely won’t wake up to find General Electric down 50 percent, unless it is involved in some kind of company-killing fraud. It can happen, of course, but it isn’t likely. Google, however, is a different story. It is still in the hard-to-value stage of its life cycle. Once Wall Street figures out how to evaluate it, it could go down just as fast as it went up; faster, in fact, because stocks do fall faster than they go up. You could wake up one day and see that Google’s business model has changed drastically, and the stock could plunge 25 percent.
You should leave a stock like Google more room for movement. Because you have to give it more slack, you should not allocate the same dollar amount to Google as you would General Electric. Google is as inclined to fall 25 percent as General Electric is to fall 5 percent. Blackstar’s mechanical trend-following method would be difficult to follow at the total portfolio level because you would have to mathematically keep track of all the positions and stops and continually adjust prices.
Another widely used trailing stop-loss order is based on percentages. Using that method, you would instruct your brokerage firm to sell a stock if it falls a certain percentage. For example, if you bought a stock at ten dollars a share and set a 10 percent trailing stop-loss order, the stock would be sold if the price falls to nine dollars. If that stock goes up to twenty dollars a share, it would then be sold if the price falls by 10 percent of twenty, which is eighteen dollars. You might want to set a higher percentage for Google than for General Electric in order to give it more room. This method is less precise than Blackstar’s ATR method, but it is simpler to calculate and easier to follow.
Remember that you are creating boundaries and not hard-and-fast rules. You don’t have to panic when a stock price goes down near where it will be sold, but you do have to be on full alert to decide if the catalysts and the trend are still in place. Remember also that when you start really stretching those boundaries, bad stuff starts to happen.
Picking Market Tops and Bottoms: A Fool’s Game
There is a lot of sex appeal associated with picking tops and bot-toms, but it is a fool’s game unless you are actually in the business of doing that, like a media personality who gets paid silly money to make predictions. To be successful you will do a lot more sitting and watching. It is the news on page ten that makes big money.
Practice Your Form
If you develop good money-management habits, when markets turn bad for extended periods of time, your stock exposure will dwindle, not increase. You will automatically stay in the game. It will affect you because it affects everybody around you, but it won’t be eating away at your portfolio. You will realize, I’m wrong. I’m selling. I know where to look for the next opportuni-ties—on the all-time-high list. In the stock market, no matter what your strategy might be, you have to be disciplined.
If you are disciplined, if your form is good, if you keep doing the same right thing over and over, good things will happen. A strong market will reappear and you will have a clear mind and money to invest. Good form means that you are thinking longer term, you are sticking to the all-time-high list, and you practice sound money management. Do these things over and over and you are going to catch a three- to five-bagger. There will be periods when the ball looks as huge as a grapefruit. You can’t miss. And then there will be other times when you are doing everything right and it looks like a seed. You can buy the greatest growth stock in a bad market, and the next day, after it hit an all-time high, it is down ten points. It happens.
In 2007, I caught four in a row: Apple, Chipotle, Crocs, and Baidu. I got into that sweet zone where the ball looked as big as a grapefruit. I considered myself lucky, and I did not overthink it. I did not try to pick a top, but as I blogged throughout 2007, I took profits along the way. I knew all four were overvalued in the “textbook” form of the word, but I let the price dictate my action.
The best thing that can happen for you is a good market. If you stay in the game, a good market will eventually come along, like an ocean that just sweeps you and everyone else with it. It is a beautiful thing to be swept along with the flow of money, and there will be periods of great returns. It won’t always be like that. There will also be periods when owning stocks is painful to your wallet. Google won’t run. Chipotle won’t run, even if they’re opening fifty stores a week. Few stocks will be hitting all-time highs. The mood will have changed in the market as well, and you will end up watching from the sidelines because your money management will have automatically taken you out of all that mess. You may have lost some percentage of your money, but those losses will generally have come after your biggest gains.
Cheating: Fear and Greed
This usually happens after prolonged good runs and bad runs. You cheat. You try to pick a bottom or turning point. You buy a stock early, predicting an all-time high before it happens because the market is strong. We all cheat. It is lazy and we know it, but we do it. Maybe the stock is only 5 percent away from an all-time high and the market is good. I did that with Coinstar (CSTR), the company that owns self-service coin-counting machines. I saw their machines because my wife uses them, and I became enamored with the company and started following it.
I bought the stock about 5 percent below an all-time high, on the way up. Co-instar’s earnings came out and the stock fell hard. I got stopped out. I crossed a set boundary by gaming an all-time high, and I also bought the stock just before an earnings announcement. I suffered the consequences when the earnings were announced. I watched the stock fall rapidly and got stopped out. If it had gone up one more dollar to an all-time high before I bought it, would I have felt better about it? I actually would have; I would have lost more money paying out that additional dollar and end up getting stopped out anyway, but I would have avoided feeling that I’d jumped the gun and gotten a little lazy about sticking to my boundaries. What I should have done was watched it a little longer and not stretched my boundaries.
I tend to make the cheating mistake, but I have not been immune to greed and tips. It rarely ends well. Examples follow later in the book.
Financial Leverage: A Dangerous Tool
I have seen it firsthand and it is evil. Fortunes have surely been made, but leverage—borrowing to invest in the stock market—is not something I could recommend for the average investor. Not ever. I think it can be used for a day or a week, and, at the proper times, for a month or two, but only as a short-term tool. To use it as a constant strategy is just is not smart for 99 percent of investors. Leverage is a very dangerous tool because things unwind very fast in the stock market.
In 1999, I was a partner in a small broker-dealer. I was overmatched, but that’s another book. One of my partners was a wealthy, wealthy man. He had made and lost fortunes in the scrap business and was in a fortune period. We had grandiose office space and were riding high. We were our biggest clients. He had leveraged his blue chip Waste Management stock that he earned from selling his scrap business to CMGI, Yahoo, Amazon, and the rest of the tech bubble. He was, for a time, killingit. Goldman Sachs, his lender, loved him too. I knew nothing, of course, because I would walk into his office while he was barking out 20,000 shares CMGI buy orders to tell him he should be selling. He would be up $100,000 by the time his confirm was back. I was the “putz,” the “wimp.”
I remember the summer of 1999, because that was the beginning of the end for my partner and our firm. Waste Management was basically halved in price on accounting “discrepancies.” I love that word discrepancy. The real meaning: fraud! Goldman Sachs was calling, but for a different reason this time. Not to lend, but to collect. When you get a margin call, don’t ignore it. Sell what you can to pay it off the minute you get it and move on. De- leverage. My partner did not. When Waste Management continued to drop and the Internet stocks began to tank later that year and into 2000, it did not take long to unwind twenty years of hard work. It took six months, actually, helped by a loose Goldman Sachs and a lack of basic money management and discipline. Combined with the eventual Waste Management liquidation to meet margin calls and the tax consequences of the sales (still a capital gain), the losses were crippling. The amount lost was well north of $50 million: real money.
In a good market, leverage works great. You buy a hot trending stock, and the money you borrowed doubles or triples, and you forget you borrowed it in the first place. Using leverage like that makes you feel giddy on the upside, but you can blow up very quickly. The only way to stay in the game and find that next great trend is not to blow up. Even if you are right about leverage and it works for you the first time, it will come back to haunt you.
Summary
Focus on the following items to make money from trend investing:
1. Scanning the all-time-high lists for the best stocks you can relate to and understand
2. Narrowing your selections down to the companies with the most unique growth opportunities, and
3. Focusing on a system that allows you to ride those winners as long as possible.
To-Do List
1. Survive. Don’t let one trade or investment put you out of business.
2. For every major money-management decision, ask, What losses can I live with?
3. Never buy a stock without an exit strategy.
4. Make use of trailing stops.
5. Sell on the way up.
6. Paper trade and slow down. There is no rush.
7. Financial leverage: avoid.