Friday, August 1, 2008

Rule 2 - Take Profit, Cut Loss, Money Management

NASDAQ in Times Square, New York City.Image via WikipediaWhile a buy and hold strategy for equities is advocated by many financial advisors or even gurus, they are using timeframe of investment as a basis for making that argument. Usually, the time frame they are talking about is 15 years onwards as historical returns have shown in the long run, equities do outperform bonds and other asset classes and it averages around 7-10%. If you are interested in long run averages in stock and why stock is a good investment, you can read Stocks for the Long Run by Jeremy Siegel

However, in the short-run, you better have some idea of money management and when to take profit and cut loss. In other words, a bit of active management is required on your part.

For the whole portfolio, an approach called rebalancing is necessary. Rebalancing means selling your outperforming asset class and buying your underperforming asset class. The rebalancing frequency often suggested is semi-annully or yearly as anything more frequent might not give you any added returns. This requires you to examine your portfolio asset allocation and "rebalance" your asset classes percentage back to the desired allocation percentage. This will shift your portfolio back to your desired risk-return characteristic.

Rebalancing, if done correctly, will force you to 'Sell High(sell outperforming asset), Buy Low(buy underperforming asset)'. It's a discipline enforced on you to take profit.

For individual invesments within the asset classes, you need to adopt a disciple of taking profit and cutting losses. This is because no one can get a 100% accuracy on his/her investment views. You might have done serious mental work on which investment might be the next performer but what if you are wrong? Are you going to stick to your investment and usually, you become emotionally attached to your invesmtent. Or when your high flying investment takes a 20% drop, do you think it's time to re-evaluate your decision on the investment?

A way to achieve an emotionless investing approach to taking your profit and cutting your loss is to adopt a trailing stop loss strategy. This requires a fair bit of active monitoring on your part. Whenever you buy into an investment (especially stocks), do a mental trailing stop loss strategy of 20%. This requires you to ensure that your investment never drops more than 20% off its highest traded price. I use 20% as it is within my comfort level and I do not get stop out so frequently. You will have to find a percentage you feel comfortable with, though anything below 10% is most likely detrimental to your strategy as you can see the annualized volatility for stocks is around 15%.

Yes, the investment might rally after the 20% drop, but what if you are wrong? The investment might languish in that trading range for a long time. There are so much investment opportunities out there, don't let a bad investment decision tied you up.

If you bought into an investment and your investment soared 50%, you still need to do a mental trailling stop loss. Should the investment drops 20%, you take your profit! This ensures you have a 30% profit in hand for other investment opportunities and not wait for the investment to drop further and reduce your profit.

Lastly, for whatever investment you made, you need to adopt a proper money management technique. Run your investment portfolio like you are a fund manager! Adopt proper position sizing by allocating no more than 5%(maximum) of your total investment value into any investment. This way, you can ensure that a 20% loss on any of your investment will translate only to an insignificant 1% loss in your total investment value.

You might argue that this also means that a 20% gain in any of your investment will translate to only 1% gain in your total investment value. Look at the BIG PICTURE! If you were a good investor and allocate 5% to every investment, you will have 20 investments in your portfolio. If you achieve a 20% gain in all of your investments within a 1 year period, your total gain for your portfolio will be 20%! Congratulations! You are on the same level as Warren Buffet who averages 23% on compounded annual growth. Just kidding, you have to achieve that at least 10 years in a row for any one to believe you are in the same league as Warren Buffett.

So remember, do not over-allocate and let one bad investment decision deciminate all your gains accumulated by other investment. In the long-run, you will be better off!

Yes, you won't get rich fast, but you won't be a pauper either.

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